UNIT 1 1.1 1.1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.

9 BANKING STRUCTURE TYPES OF BANKS TRADITIONAL BANKING FUNCTIONS IMPORTANCE OF TECHNOLOGY IN BANKING INDUSTRY BANKING REFORMS IN INDIA NARASIMHAM COMMITTEE I NARAMSIMHAM COMMITTEE II CAPITAL ADEQUACY RATIO BASEL COMMITTEE REPORT I BASEL II ACCORD SUMMARY QUESTION BANK

The banking system forms the core of the financial sector of an economy. Role of commercial banks is particularly important in undeveloped countries through mobilization of resources and their better allocation commercial banks play an important role in the developmental process of underdeveloped countries. A commercial bank is a financial intermediary which accepts deposits of money from the public and lends them with a view of making profits. A post office may accept deposits but it cannot be called a bank because it does not perform the other essential functions of a bank i.e., lending money. Similarly some other institutions like Unit Trust of India (UTI) may be lending to others but since they do not accept cheque deposits, they cannot be termed as banks. They are non- banking financial institutions. By offering attractive saving schemes and ensuring safety of deposits, commercial banks encourage people to save their earnings. By reaching out to people in rural areas they help to convert idle savings into effective ones. Commercial banks improve the allocation of resources by lending money to priority sectors of the economy. These banks provide a meeting ground for the savers and the investors. 1.1. BANKING STRUCTURE

The commercial banks are spread across the length and breadth of the country cater to the short term needs of industry, trade, commerce and agriculture, while the developmental banks focus on long term needs. These days the commercial banks also look after other needs of their customers including long term credit requirement. 1.1.1. TYPES OF BANKS: Commercial banks operating in India may be categorized into: Public sector banks Private sector banks Foreign banks Depending upon their ownership, management and control. They may also be differentiated as: Scheduled banks Non scheduled commercial banks

Fig 1.1: BANKING STRUCTURE

RBI

SCHEDULED BANKS (63)

NON SCHEDULED BANKS

PUBLIC SECTOR BANKS (26)

PRIVATE SECTOR BANKS

FOREIGN BANKS ((32)

REGIONAL RURAL BANKS

LOCAL BANKS

OLD PRIVATE SECTOR BANKS (14)

NEW PRIVATE SECTOR BANKS (7)

i.

SCHEDULED BANKS:

The second schedule of the RBI Act contains a list of banks which are described as scheduled banks. A bank in order to be designated as a scheduled bank should have a paid up capital and reserves as prescribed by the Act. In terms of section 42(6) of RBI Act, 1934, the required amount is only Rs.5 lakhs. However, presenting to start a commercial bank, the RBI prescribe a minimum capital of Rs.100 crore and its business must be managed in a manner which in the opinion of RBI, is not detrimental to the interests of its depositors. The scheduled bank is also required to maintain with the RBI a deposit in the form of Cash Reserve Ratio and Statutory Liquidity Ratio based on the demand and time liabilities at prescribed rate. The scheduled banks enjoy several privileges. An account with a scheduled bank carries a greater assurance of safety and prestige value than an account with nonscheduled bank. It is entitled to receive refinance facility as applicable. It may also get currency chest facility. So, at times of urgent need, it may obtain finance from the RBI to help in tiding over temporary financial difficulties. Furthermore, the settlement of accounts
3

between scheduled banks is facilitated by the use of bankers sharing those procedures. On the other hand, scheduled banks have to submit several returns to the RBI and are obliged to comply with the directions received from the RBI. Some of these returns are to be submitted every week usually on Friday. The affairs of the scheduled banks are closely watched and largely controlled by the RBI, in order to safeguard the general health of the banking industry as a whole.

ii.

NON-SCHEDULED BANKS:

The commercial banks, not included in the second schedule of the RBI Act are known as non-scheduled banks. They are not entitled to get facilities like refinance and rediscounting of bills etc., from RBI. They are mainly engaged to lending money, discounting, collecting bills and various agency services. They insist higher security for loans as on December 1999 there was only one on-scheduled bank, viz, Sikkim bank ltd, later it was merged with Union bank of India. FIG 1.2: SCHEDULED AND NON- SCHEDULED BANKS

SCHEDULED BANKS

NATIONALISED BANKS, STATE BANK OF INDIA AND ITS SUBSIDIARIES, PRIVATE SECTOR BANKS AND FOREIGN BANKS.

NON - SCHEDULED BANKS

THEY ARE THOSE WHICH ARE NOT INCLUDED IN THE SECOND SCHEDULE OF RBI ACT.

iii.

PUBLIC SECTOR BANKS:

The Central Government entered the banking business with the nationalization of the Imperial bank of India in 1955. In 1969, 14 large banks were nationalized. And again in 1980, 6 more banks were taken over by the government. After the nationalization these banks render various types of functions by assuming social responsibilities through these banks, the government tries to implement its Fiscal policies and various welfare schemes. These banks occupy a pivotal place in the Indian banking system. State bank of India and its subsidiaries are also commercial banks providing services similar to that of nationalized banks. They are also called as public sector banks. Large scale branch expansion, mass recruitment of staff to take banking to gross roots level, direct investments and credit programmes administered interest rate regime, credit dispensation towards poverty alleviation programmes through loan melas etc, ruled the roost in the Indian banking scene for over two decades. However, now the public sector banks are on the fast track of transformation. The process of transformation of the public sector banks were led by the outset of technology. Many banks having moved to the core banking platform, could offer global standards of customized service he customers. Thus, the era of technology drove banking environment, gradual process of modernization of bank branches and it began to change the working environment making it more conducive for the employees to deliver quality service with much more commitment.

FIG 1.3: PUBLIC SECTOR BANKS

LIST OF PUBLIC SECTOR BANKS IN INDIA 10. INDIAN BANK 11. INDIAN OVERSEAS BANK 19. STATE BANK OF TRAVANCORE 20. SYNDICATE BANK 21. UCO BANK 22. UNION BANK OF INDIA 23. UNITED BANK OF INDIA 24. VIJAYA BANK

1. ALLAHABAD BANK 2. ANDHRA BANK 3. BANK OF BARODA 4. BANK OF INDIA 5.BANK OF MAHARASHTRA 6. CANARA BANK 7. CENTRAL BANK OF INDIA 8. CORPORATION BANK 9. DENA BANK

12. ORIENTAL BANK OF COMMERCE

13. PUNJAB AND SINDH BANK 14. STATE BANK OF BIKANER AND JAIPUR 15. STATE BANK OF HYDERABAD 16. STATE BANK OF INDIA 17. STATE BANK OF MYSORE

25. IDBI BANK

26. SAURASHTRA GRAMIN BANK

18. STATE BANK OF PATIALA

iv.

PRIVATE SECTOR BANKS:

All those banks where greater parts of stake or equity are held by the private shareholders and not by government are called as the private sector banks. These are the major players in the banking sector as well as in expansion of the business activities India. The present private sector banks equipped with all kinds of contemporary innovations, monetary tools and techniques to handle the complexities are a result of the evolutionary process over two centuries. They have a highly developed organizational structure and are professionally managed. Thus they have grown faster and stronger since past few years. The banks before the nationalization of banks that took place during 1969 and 1980 are known to be the old private sector banks. These were not nationalized, because of their small size and regional focus. Most of the old private sector banks are closely held by certain communities their operations are mostly restricted to the areas in and around their place of origin. Their Board of directors mainly consist of locally prominent personalities from trade and
6

business circles. The banks, which came in operation after 1991, with the introduction of economic reforms and financial sector reforms are called as new private sector banks. Banking regulation act was then amended in 1993, which permitted the entry of new private sector banks in the Indian banking sector. However, there were certain criteria set for the establishment of the new private sector banks. Some of those criteria being: 1. The bank should have a minimum net worth of Rs. 100 crores. 2. The promoters holding should be a minimum of 25% of the paid up capital. 3. Within 3 years of the starting of the operations, the bank should offer shares to public. FIG 1.4: List of the new private sector banks in India

1. AXIS BANK 2. BANK OF PUNJAB 3. CENTURIAN BANK OF PUNJAB 4. DEVELOPMENTAL CREDIT BANK 5. HDFC BANK

6. ICICI BANK 7. INDUSIND BANK 8. KOTAK MAHINDRA BANK 9. YES BANK

v.

FOREIGN BANKS:

Till the 1950s they were called exchange banks because they alone transacted most of the import and export financing business in India. The Foreign banks are branches of joint stock companies incorporate abroad, but operating in India. They are foreign in origin and have their head office located in their parent country. Many foreign banks opened their offices and expanded branches after the opening up of the Indian entirely new economy in the 1990s. These banks created an entirely new playing field in the banking sector through their rays of products and services including ATMs, electronic services, credit cards and port folio management. They provide foreign currencies for bonafide purposes like trade, travel or for studying abroad.

vi.

REGIONAL RURAL BANKS (RRB):

Regional Rural Banks how been setup in backward rural areas where the coverage of the commercial and co-operative banks is poor. The purpose of these banks is to finance agricultural operation and provide employment to rural educated youth who possess the requisite orientation to after the needs rural people. RRBs were incorporated to combine the strong points of both the co-operative and commercial banks eliminating the weaknesses of both. The RRBs are included the second schedule to the RBI Act. vii. LOCAL BANKS:

The local area banks scheme was introduced in August 1996. The idea behind setting up of new private local banks was to help the mobilization of rural savings by local institutions and make them available in the local areas. The local area banks were expected to bridge the gaps in credit availability in rural and semi-urban areas. 1.2. TRADITIONAL BANKING FUNCTIONS :

In very general terms the traditional functions of a commercial bank can be classified under following main heads: FIG 1.5: FUNCTIONS OF COMMERCIAL BANKS:

RECIVEING DEPOSITS

MISC FUNCTIONS

FUNCTIO NS OF BANKS

LENDING OF MONEY

TRANSFER OF MONEY

i.

Receiving of Money on Deposit :

This is perhaps the most important function of commercial bank, as it is largely by means of deposits that a bank prepares the basis for several other activities. The money
8

power of a bank, by which it helps largely the business community and other customers, depends considerably upon the amounts it can borrow by way of deposits. The deposit o the bank can take the form of fixed, savings or current deposits. All these go towards augmenting the resources of bank. Deposits: Deposits are the main sources of funds for commercial banks which plays very important role in the economic life of the country through their assistance to trade, commerce, industry and agriculture. The owned funds of banks are comparatively negligible portion of the total working funds with which banks carry on business . the bulk of total liabilities of banking companies compromise deposits. Since bank serve financial needs of various sections of society, the larger the volume of funds they attract, the better the position they are in to lend funds. The volume of deposits with a particular bank indicates not only the confidence, which the public reposes in it but also its stability to assist the economic activities and growth and development of the country. FORMS OF DEPOSITS: One of the main functions of commercial banks is to accept deposits of various types on different terms and condition. The deposits accepted by banks maybe categorized in following broad categories: Demand Deposits Term Deposits

Demand deposits are those deposits which can be withdrawn by the customer on demand without notice. Banks undertake to repay such deposits on demand. Such deposits include: Current deposits Savings bank deposits Call deposits Term deposits are those which are not repayable on demand. Such deposits are repayable after a fixed date or after a fixed period of notice. Such deposits include: Fixed deposits Recurring savings deposits These are the broad categories of deposits accepted by banks. However, banks may develop various products by incorporating various customer friendly and attractive features/ service in such deposits such as periodicity of payment of interest, reinvestment facility for principal or interest, before maturity payment of term deposits, etc.,
9

i.

Current Accounts

A current account is a running account and is usually opened for the purpose of business. A current account is meant for the convenience of his customers, who are relieved of task of handling cash themselves and to take the risks inherent therein. Current account maybe opened by individuals, proprietorship/ partnership firms, limited companies, association/ societies, local bodies/govt. departments, liquidators/ receivers etc. for opening an account the customer has to fill in the prescribed account opening from and provide an acceptable introduction to the bank. As per percent practices in India, the customer has to provide proof if address as well as permanent account number(PAN) given by the Income Tax department along with photograph of the account holders and specimen signatures of the person authorized to open the account. A customer is required to deposit the prescribed initial amount to open the account and to always maintain the minimum required credit balance in the account. The customer can pay in cash/ cheques foe collection and draw cheques freely to shoot his business requirements. There is no restriction on the number and the amount of withdrawals from a current account. The customer is provided with cheque books for drawing cheques to draw money from the account and/ or to make payment to third parties. In the current accounts, the banker incurs an obligation to pay all cheques drawn by the account holders so long as their sufficient balance to his credit and the cheques drawn are technically in order. The account holder id obliged not to draw cheques without maintaining a sufficient balance to his credit. In a current account there is no limit on the amount or the number or withdrawals. No interest is allowed on the credit balance in current account. The banks also charge some incidental/ service charges for rendering service in current accounts. Arrangements can be made in current accounts to allow overdrafts, which maybe clean or secured. Overdraft maybe allowed by the bank for a temporary period or for a longer period depending upon, the requirement and relationship with the customer. Banks may allow facility like bills purchased/ discount to approve current account holders. ii. Savings Bank Accounts:

A savings bank account is meant for the people of the lower and middle classes who wish a save a part of their current incomes to meet their future needs and also intend to earn income from their savings. These accounts are open for the purpose of encouraging the savings habit. Savings bank account opened by individuals, guardians on behalf of minors, clubs/ association, charitable trust/ religious institutions and similar bodies. Savings bank account cannot be opened for trading/ business concern/ limited companies/ govt. departments etc. for opening an account the customer has to fill in the prescribed account opening from and provide an acceptable introduction to the bank. As per present
10

practices in India the customer has to provide proof of address as well as permanent account number (PAN) given by the Income Tax department along with photograph of the account holder and specimen signature of the persons authorized to open the account. Interest is allowed on the minimum balance maintained in the account during the specified period in every month say between 10th of every month to the last date of the month*. Interest is credited in the account on half yearly intervals@ 3.5% rate of interest the number of withdrawals and the maximum amounts which can be withdrawn, without prior notice, at a time maybe restricted. Banks may frame rules in this regard, which may vary from bank to bank and from time to time. Withdrawals from savings bank account maybe effected either through a withdrawal form or cheques issued from the cheque book pertaining to the account. iii. Call Deposits:

Call deposits are accepted from fellow bankers and are repayable on demand. Interest in call deposits normally depends upon demand for the money and its supply in the financial market. iv. Fixed Deposits:

In this category are included the deposits with the bank for a fixed period which is specified at the time of making the deposit. Fixed deposits are accepted for a specified period and carry a specified rate on interest. The deposits are repayable on the expiry of the specified period, chosen by the depositor. The depositor agrees not to withdraw the amount earlier. At the end of the specified period, the depositor may either withdraw the amount or renew the deposit for a further specified period. The fixing of the period, enables the banker to deploy the funds suitably without fear of demand for withdrawal, deposits during the specified period of deposits. As the date or repayment or a fixed deposit is determined in advance, the banker need not keep more cash against it and can utilize such amount more profitability. The banker, therefore, offers higher rate of interest, in October 2008, it was 11% for 1000 days by SBI on such deposits because the depositor parts with liquidity for a definite period. Fixed deposits provide stable funds to banks and are therefore very popular among bankers. When a fixed deposits is accepted by the banker he gives the deposits a receipt maintaining the date of deposit, the name of depositor, the rate of interest allowed on such deposits, the amount of deposit and the period for which the amount is deposited. The due date of deposit is also mentioned on the receipt. The rules governing the deposits are printed on the reverse of the receipt for the information of the depositor authorizing payments to the third party or the collection banker as the case may be.
11

If a deposit receipt is lost or stolen, the amount can be paid to the depositor on the due date on obtaining and indemnity, as a deposit receipt is not a transferrable instrument and its transfer as no legal value. In case of renewal/ repayment of deposit receipt, surrender of duly discharged receipt by the depositor is necessary. Interest on deposit ceases to accrue on overdue receipts after maturity of the receipt but the banks may, at their discretion, allow interest thereafter if the fixed deposit is renewed from the date of which maturity till a future date. A fixed deposit receipt is accepted for a fixed period and need not be repaid before the due date. However, if the depositor is in need of money before the due date, the banker may consider favourably the request for prepayment. In such cases, the interest is paid at rates lower than the rates applicable for the period for which the deposit run. Alternatively the banker may grant the depositor an advance against the deposit after retaining margin. The interest charged on advance against deposit is generally 1 to 2% higher than the rate payable on deposit. Under reinvestment plan of fixed deposit the interest accrued on fixed deposits is periodically and automatically reinvested in the fixed deposits with the same rate of interest and is paid to the depositor on maturity of the deposit. Such schemes are designed to facilitate maximum return to the deposit by the way of reinvesting the element of interest at the same rate.

v.

Recurring Deposits:

With the object of giving the small depositors and incentive and convenience to save, banks allow recurring deposit facility to their customers. This facility in intended to inculcate the habit of savings on a regular basis as an inducement is offered in form of a comparatively higher rate of interest than the saving bank. Under these, the depositors may pay a fixed sum of money every month for various periods, say 12 to 120 months. The deposits may pay the money in easy installments and yet attractive interest rates. There is also an element of compulsion in the recurring deposit scheme and the depositor can conveniently build up a sizable amount over a period. The depositor, if he so desires, may get back the money deposited by him even before the stipulated period. In such cases, the interest payable by the bank will, however, be at the rate lower than agreed at the time of opening of an account. These are the broad categories of deposits accepted by banks. However, banks may develop various products by incorporating various customer friendly and attractive features/services in such deposits such as periodicity of payment of interest, reinvestment
12

facility for principal or interest, before maturity payment of term deposits, etc. Some of the examples of such deposits are as under:

vi.

Flexi- Deposit:

Under this scheme the amount over and above a certain pre determined level, is transferred from a savings/ current account to a term deposit account automatically in certain pre determined amount of units of pre determined period and such amount starts earning higher rate of interest. Whenever, there is a shortfall current/ savings account and the balance is not sufficient to pass the cheques/ meet the requirements, the requisite amount is transferred from the term deposit account by breaking and making premature payment or equivalent units to meet the shortfall in the account.

ii.

Lending of money:

This function is, not only very important, but is the chief source of profit for commercial banks. By lending money banks place funds at the disposal of the borrower, in exchange for a promise of payments at a future date, enabling the borrowers to carry on their business/ productive activities and meet their other requirements. Banks, thus, help their clients to meet their needs with the money lent to them and return the money with interest as per agreed terms. The advances of a bank can take the form of loans, cash credits, bills purchased/ discount facilities. All these go towards augmenting the resources of the borrowers. As mentioned earlier banking involves accepting of deposits from public for the purpose of lending or investment. Lending of funds to constituents, mainly traders, business and industrial enterprises constitute the main business of any bank. Advances comprise a large portion of a banks total asserts and form the backbone of the banks structure. Advances play an important part in gross earnings of banks. The major part of banks income is earned from interest and discount on funds lent by them. The income so earned is used for payment of interest to his depositors and also for payment of salaries to its employees and dividend to shareholders. If a bank does not make advances of investments and keep the funds idle it will not earn income and consequently will not be able to pay depositors/ employees, etc., and consequently will not be able to carry on business profitably. The strength of a bank is primarily judge by the soundness of its advances. Thus, the advances of a bank play a very important role in operations of a bank. Types of Credit Facilities:

13

The credit assistance provided by a banker is mainly of two types. One is fund based credit support and the other is non-fund based. The difference between fund-based and non-fund based credit assistance provided by a banker lies mainly in the cash outflow. While the former involves immediate cash outflow, the latter may or may not involve cash outflow from a banker. Banks may allow funds based facilities to customer in any of the following manners: By allowing overdrafts (clean/secured) By sanctioning cash credit limit By way of demand loan By granting term loan By purchasing/discounting bills

a. Overdraft: When a customer, who has a current account, is allowed by the bank to draw more than his deposits in the account, such facility is called an overdraft facility. In this facility, the customer is permitted to withdraw the amount as and when he needs it and to repay it by means of deposits in his account as and when it is convenient to him. Overdraft is generally granted against Govt. or other securities, fully paid shares, fixed deposits, etc. it may also be allowed for short/temporary period without security in which case the same is known as clean overdraft. b. Cash Credit: A cash credit account is a drawing account against a fixed credit limit granted by the bank and is operated exactly in the same manner as a current account with an overdraft facility. Cash credit limits are granted by the banks against pledge/ hypothecation of goods/ book debts/ documents of title to goods, etc., depending upon the nature requirement of borrower. Under the system of bank specifies a limit for the customer, up to which the customer is permitted to borrow against the security of assets after compliance of prescribed terms and conditions and keeping prescribed margin against the securities. The customer withdraws from his cash credit accounts as and when he needs the funds and deposits any amount of money which he finds surplus with him on any day. The cash credit account is thus, an active and running account to which deposits and withdrawals may be effected frequently. c. Demand Loan: A Demand loan is an advance for a fixed amount and no debits to the account may be made subsequent to the initial advance except for the interest, insurance premium and
14

other sundry charges. Generally, banks provide the demand loan for periods not longer than twelve months. d. Term Loan: A Term loan is an advance for a fixed period for persons engaged in industries, business or trade for meeting their requirements like acquisition for fixed assets like land, building and machinery. Such loans may be also allowed to individuals for the purpose of purchasing houses / consumer durable in which cases the same are termed as housing loans / personal loans etc. the repayment of the term loans may be made in installments which are fixed by the bank taking into consideration the repayment capacity of the borrower. A term loan may be sanctioned for a medium term or for a long term. e. Purchase/ Discount of Bills: Banks may also allow bills purchasing/ discounting facility to customer by either purchasing demand bills or discounting bills. After purchasing/ discounting bills the banker may send the bill for collection of proceeds from the drawee of the bill and on receipt of proceeds the bills are adjusted. In case the bills are not paid by the drawee the banker recovers the amount of the bill and interest thereon from the borrower. f. Letters Of Credit: A Letter of Credit is a mechanism which helps a trade transaction to be put through between a seller and a buyer. A Letter of Credit is an arrangement whereby a banker acting on the request of customer, undertakes to pay a third party, by a given date, according to the agreed stipulation and against presentation of documents, the counter value of the goods and services rendered otherwise. A letter of credit is thus, an arrangement by which a buyer enables a seller to get the value of the bill of his supplies effected as per agreed terms and on his tendering the stipulated documents of the relative consignment to a banker on or before a given date. The banker after making payment of the bill to the seller presents it to the buyer and obtains payment of it. The buyer who establishes the Letter of Credit is known as the Opener of LC. The banker who establishes the LC at the request of the buyer is called the LC opening bank and seller in whose favour the LC is established is known as the beneficiary of the credit. LCs may be issued by banks on DP or DA terms for import / domestic transactions. Bank charges commission for service and the facility rendered/ commitment made by him. There are various types of LCs, viz., Acceptance of Credit/ Revocable Credit/ Irrevocable Credit/ Confirmed Credit/ With recourse and without recourse credit/ transferable credit/ back to back credit/ red-clause credit/ green-clause credit/ revolving letter of credit, etc.
15

g. Letters Of Guarantee: In commercial transaction, banks customers are sometimes required to give a bank guarantee mainly as an alternative to provide cash security against a contract entered with another party. The third party that seeks the guarantee not being aware of the customers financial standing prefers a bank guarantee. In turn the banker who understands the financial standing of the customer undertakes to guarantee the customers financial commitments or the performance of the contract by him. LGs issued by a bank may be in the nature of performance guarantee, financial guarantee, deferred payment guarantee, statutory guarantee, etc, depending upon the nature of the contract and the commitment. The banker issuing the guarantee charges commission for the services rendered and the commitment made by him. There are banks obligations in guarantee to pay primary. Commitments of banks must be honoured free from interference by the courts. iii. Transferring money from place to place:

This function is also one of the important functions of commercial banks. Banks allow the facility to transfer of funds by issuing Demand Drafts, Telegraphic/ Telephonic Transfers, Mail Transfers, etc. Efficient funds clearing system makes use of magnetic ink character recognition technology. Other electronic services include: a. Retail payment system: It facilitates cheque clearing, electronic fund transfer through National Electronic Funds Transfer. b. Large value system: Facilitating settlement of inter bank transactions from financial markets. These include: Real time gross settlement system Securities settlement System Foreign exchange clearing iv. Miscellaneous functions:

Safe custody of valuables, issue of various forms of credits e.g., letters of credit travellers cheques and furnishing guarantees on behalf of customers and providing fee based services are also important functions performed by commercial banks. Traditionally these are the main functions being performed by commercial banks. The functions have however, undergone a sea change with the development of technology,
16

globalization of economy transforming the world into big village and consequent development of new concepts of modern banking. E-banking is the latest function performed by the banks using the advantages of technology. 1.3. Importance of Technology in Banking Industry:

All the new financial products that have been created in recent years contribute economic value by unbundling risks and reallocating them in a highly calibrated manner. The importance of Technology in banking industry are as follows: a. Opens new avenues of market opportunities: Technology has opened up new markets, products services and efficient delivery channels for the banking industry. b. Provides ability to deal with the challenges:

AUTOMATIC TELLER MACHINES: Teller machines are those which are used within or outside the bank premises for cash payments and other transaction related services without intervention of human being. ATM is a device that allows customers who have an ATM card to perform routine banking transactions without interacting with a human teller. ATM enables a customer to withdraw cash, know latest balance in account and order for statement of account to third parties. ATMs are currently becoming popular in India that enables the customers to withdraw their money 24 hours a day and 7 days a week. ATMs are installed in different forms as wall unit, window unit or lobby unit depending upon the location and the need of target customers. A customer who wishes to utilize the service of ATMs will have access to it only with an ATM card. The ATM card consists of a personal identification number, which is known only to the slot before starting his operation and he will be able to transact his business through interactive visual display unit and the keyboard. The ATM card is different from a credit card. The essential difference between the credit card and the ATM card is that the former offers credit as the name suggests, whereas the latter in a networked environment allows the account of the cardholder to be directly debited

1.4.

BANKING SECTOR REFORMS IN INDIA

17

The government had helped create and develop uniformity in the operational structure of the banks through the enactment of the Banking Regulation Act as back as in 1948. Until 1991, the banking in India was largely straight and traditional. The bankers were Prudent and cautious men who seldom took risks and were content with the normal banking activities of accepting deposits and leading against them. Labeled as Agents of Social Change , their outlook was rigidly controlled by the policies of the Government, which were centered more on the alleviation of poverty and in the upliftment of the downtrodden. The Nationalization of banks in the years 1969 and 1980 brought the private banks under state control, with the objective of realizing this government dream. Even as late as 1991-92, the profitability was a forbidden word in banking business. Lending to the priority sectors, opening of rural branches, achievements in Implementation of Government sponsored schemes and generally toeing the line in adherence to the policies and programmes of the Government were the parameters considered for judging the performance of a bank. Indian banking system has made commendable progress in extending its geographical spread and functional reach. The spread of banking system has been a major factor in promoting financial inter-mediation in the economy and in the growth of financial savings. The advent of nationalization of banks helped in increasing the number of branches, volume of deposits and ensured wider dispersal of the advances. Despite impressive quantitative achievements in resource mobilization and in extending the credit reach, the following deficiencies have, over the years crept into the financial system. The main objectives of the financial sector reforms were to: i. ii. iii. iv. v. Improve operational flexibility and efficiency i.e. reduction in costs of financial intermediation and speed thereof. Achieve allocation efficiency i.e. allocation of resources to the best possible uses. Provide internal autonomy for public sector banks in their decision making process. Enhance professionalism in banking operation. Improve productivity, efficiency and profitability of banking sector through operational flexibility and functional autonomy. NARASIMHAM COMMITTEE (1991)

1.5.

The objectives of the Narasimham committee I was to ensure the system operates on the basis of operational flexibility and functional autonomy with a view to enhancing

18

efficiency, productivity and profitability. The first committee focused on arresting the qualitative deterioration in the functioning of the financial system. i. On direct investment :

The statutory liquidity ratio (SLR) should be used as a prudential requirement rather than a major instrument for public sector financing. The committee recommended reduction in SLR to 25 per cent over the next five years , to enable banks to fund economic activities in a better way. The RBI should have the flexibility to operate cash reserve ratio (CRR) to serve its monetary policy objectives. RBI should rely more on open market operation (OMO) and reduce its dependence on CRR. To utilize the amount of RBI (kept by the banks with the RBI under CRR) for more productive and remunerative purpose, RBI should pay interest on impounded deposits of banks above the basic minimum viz., at a rate of interest equal to the level of banks one year deposits. ii. On Direct credit programme:

The direct credit programme should be phased out since it has only a very mild positive effect on output and employment. The priority sector should be redefined to include small and marginal farmers, weak industries, the tiny sector of industry, village and cottage industries, small business and business operators, rural artisans and other weaker sections, for refinancing which directed credit target be fixed at 10 percent of the aggregate credit. In fact the government seems to be lacking political will to implement this recommendation. iii. On the structure of interest rates:

The concessional interest rates for priority sector loans of small size should be phased out. So the Narasimham committee recommended that the level and structure of interest rates should be broadly determined by the market forces. The RBI should be the authority to simplify the structure of interest rates. The spread between the bank rate, the bank deposit rates, the government borrowings rates, and the prime lending rates may be determined by the RBI so as to ensure that the real rates of interest are positive. A prime lending rate (PLR) would be the floor of lending rates of banks. Nationalization of interest rates was carried out with the ultimate objective of total deregulation of interest rates. Banks were given freedom to fix the interest rates, depending upon the risks evolved prime lending rate (PLR) the rate offered to the first class clients of the banks and all other lending rates are pegged to this base rate. iv. On structural organization of banks:

To install the element of competition and efficiency, the revised system should be market driven and based on profitability considerations and brought about through a
19

process of merges and amalgamations. The structural organization of banks should evolve a broad pattern consisting of : International banks. National banks Local banks Rural banks.

International banks comprising three to four large banks including state bank of India while national banks comprises eight to ten national banks with the network of branches throughout the country engaged in general or universal banking. Local banks operation would be generally confined to a specific region while the operation and business of rural banks including Regional Rural Banks (RRBs) confined to the rural areas and predominantly engaged in financing of agriculture and allied activities. v. On capital adequacy , accounting policies and related matters :

Banks enjoying good reputation and earning profit should be permitted to issue fresh capital to the public through the capital market to enhance their capital. Uniform accounting policies should be followed with regard to income recognition and providing against doubtful assets. Sound practices in regard to valuation of investments should be adopted. In the Narasimham committee recommended the setting-up of the Assets Reconstruction Fund (ARF). It was aimed at ameliorating a portion of bad and doubtful debts at a discount. vi. Prudential regulation and supervision:

The present system of dual control over the banking system between RBI and the banking division of the ministry finance should end immediately and the RBI should be the primary agency for the supervisory authorities should be based essentially on the internal audit and inspection reports. In the appointment of Chairman and Managing Director (CMD), professionalism and integrity should be the prime consideration. They should be appointed by the government on the basis of recommendation of group of eminent persons who could be invited by the government of the RBI. To strengthen the supervision and to set prudential regulation banking sector should adopt modern and transport accounting practices including realistic assets classification and capital adequacy targets. In brief, the approach of committee of financial system (CFS) 1991, Narasimham committee I sought to consolidate the gains made in the Indian banking sector while
20

improving the quality of the portfolio, providing greater operational flexibility and, most importantly, greater autonomy in the internal operation of the banks so as to nurture a healthy, competitive and vibrant banking system. 1.6. NARASIMHAM COMMITTEE II:

The committee on banking sector reform with Mr. M. Narasimham as chairman on the same/related subject, was constituted on December 26, 1997 to review the record of financial sector reforms of the Narasimham Committee on Financial System(1991), and to suggest remedial measures for strengthening the banking system, covering areas of banking policy, institutional structure, supervisory system, legislative and technological changes. The major recommendations of the committee are summarized below: i. Strengthening the banking system:

To strengthen the banking system, the committee recommended an increase in the minimum capital adequacy ratio(CRAR) to 10 percent by 2002. Besides, the entire portfolio of Government securities should be marked to market in three years. Also, a 5 percent weightage is to be assigned for Government and other approved securities to hedge against market risk. Net NPAs have to be brought down to below 5 percent by 2000 and to 3 percent by 2002. However, banks with international presence should reduce gross NPA to 5 percent and 3 percent by 2000 and 2002, respectively and net NPAs to 3 percent and 0 percent, respectively. The committee proposed Asset Reconstruction Company(ARC) to tide over the backlog of NPAs. In case of prudential norms relating to income recognition the present norm of 180 days should be brought down to 90 days in a phased manner by 2002. As regards asset classification, an asset may be classified as doubtful if it is in the substandard category for 18 months in the first instance and eventually for 12 months and loss if it has been so identified but not written off. These norms which should be rega rded as the minimum, may be brought into force in a phased manner.

ii.

Systems and Methods in banks:

To bring about efficiency in banks, the committee recommended a number of measures. These include, revision of operational manual and its regular updation, simplification of documentation systems, introduction of computer audit, and evolving of a filtering mechanism to reduce concentration of exposures in lending and drawing geographical/industry/sectoral exposure norms with the Boards concurrence. Besides, the committee has suggested induction of one more whole time director in nationalized banks in the view of changing environment. As outsourcing of services would improve
21

productivity, it suggested the same may be introduced in the fields of building maintenance, cleaning, security, dispatch of mail, computer related work, etc. subject to relevant Laws. The committee suggested a reduction in the minimum stipulated holdings of the Government/Reserve Bank in the equity of nationalized banks/State Bank of India to 33 percent. In regard to tenure of a Chief Executive of a Bank, the committee indicated a minimum period of three years but the reasonable length of tenure to be not less than five years. iii. Structural Issues:

The committee recommended that after the convergence of activities between DFIs and banks over a period of time, they should converted into banks, resulting in the existence of only two intermediaries viz., banks and non-banks. While mergers between strong financial institutions would make sense, the weak banks in the system will have to be given a revival package subject to a set of criteria. The licensing of new private sector banks needs a review for their enhancement, while foreign banks will have to be encouraged to extend their operations on certain norms. All appointments of chairmen, managing directors and executive directors of public sector banks and financial institutions, should be determined by an appointments board. The committee felt the urgent need to raise the competency levels in public sector banks by resorting to a lateral induction of talented personnel. It also felt that the remuneration structure should be flexible and market driven. The committee recommended the corporatization of IDBI. It also desired that the minimum net worth of NBFCs should at the same time be raised to Rs.2 crore progressively. For purposes of registration with the Reserve Bank, however, the minimum limit for net worth has been doubled to Rs.50 lakh. Besides, no deposit insurance corporation for NBFCs was proposed. The committee proposed prudential and regulatory standards besides new capital norms for urban Co-operative Banks(UCBs). iv. Integration of Financial Markets:

The committee recommended that banks and primary dealers alone should be allowed in the inter-bank call and notice money markets. Non-bank financial institutions would get access to other forms of instruments in money market like bill rediscounting,
22

CPs, Treasury Bills, etc. It also suggested opening the treasury bill market to foreign institutional investors for broadening its base. v. Rural and small Industrial credit:

The committee proposed review and strengthening of the operation of rural financial institutions (RFIs) in terms of appraisal, supervision and follow-up, loan recovery strategies and development of bank-client relationships in view of higher NPAs in public sector banks due to directed lending. In regard to capital adequacy requirements, RRBs and co-operative banks should reach a minimum of 8 percent capital to risk weighted assets ratio over a period of 5 years. It also proposed that all regulatory and supervisory functions over rural credit institutions should rest with the Board for Financial Regulation and Supervision (BFRS). vi. Regulation and Supervision:

The committee made a suggestion that the Basle Core Principles of Effective Bank Supervision should be regarded as the minimum to be attained. It should be made obligatory for banks to take into account risk weights for market risks to facilitate soundness and stability of the system. For effective conduct of monetary policy by the Reserve Bank, delineation of supervision/ regulation from monetary policy is required implying that the Executive associated with monetary authority should not be in the Supervisory Board, to avoid weakening of monetary policy or banking regulation and supervision. The process of separating BFS from the Reserve Bank would need to be initiated and to supervise the activities of banks, financial institutions and NBFCs, a new agency in the name of BFRS would have to be formed. With a view to achieving an integrated system of supervision over the financial system, the committee recommended bringing urban co-operative banks within the ambit of the BFS.

vii.

Legal and Legislative Framework:

The committee recommended the amendment to RBI Act and Banking Regulations Act with regard to the formation of BFRS. It also gives more autonomy and powers to public sector banks (Nationalization Act). As wide ranging changes in the legal framework affecting the working of the financial sector are sought by the committee, an expert committee could be constituted comprising representatives from the Ministry of Law, Banking Division, Ministry of Finance, the Reserve Bank of India and some outside experts.

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1.7. CAPITAL ADEQUACY RATIO: Capital adequacy ratio is a measure of the amount of a banks capital expressed as a percentage of its risk weighted exposures. Capital adequacy ratio is the ratio which determines the banks capacity to meet the time liabilities and other risk such as credit risk, operational risk etc...In most simple formulation, a banks capital is the cushion of potential losses and protects the banks depositors and other lenders. Banking regulators in most countries define and monitor capital adequacy ratio to protect depositors, thereby maintaining confidence in the banking system.

Capital is measured under two heads in capital adequacy ratio, which are as follows: Tier I capital Tier II capital TIER I CAPITAL: Tier I capital is permanently and freely available. It absorbs losses without the bank obliged to cease its trading. It safeguards both the survival of the bank and the stability of the financial system. TIER 1 CAPITAL = paid up capital + statutory reserves + disclosed free reserves equity investments in subsidiary + intangible assets + current & b/f losses TIER II CAPITAL: Tier II capital is less permanent in nature. It absorbs losses in the event of liquidation of the bank. It provides lesser protection for depositors and creditors. TIER II CAPITAL = Undisclosed Reserves + General Loss reserves + hybrid debt capital instruments + subordinated debts. MINIMUM REQUIREMENTS OF CAPITAL FUND IN INDIA: Existing Banks 09 % New Private Sector Banks 10 % Banks undertaking Insurance business 10 %

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 Local 1.8.

Area

Banks

15%

BASEL COMMITTEE REPORT

The Basel Committee on banking supervision was established as the committee on Banking Regulations and Supervisory Practices by the central bank governors of group of ten countries at the end of 1974 in the aftermath of the serious disturbances in international currency and banking markets. The first meeting took place in February 1975 and the successive meetings were held regularly three or four times a year since then. The Basel supervisors committee endorsed Basel I in 1988. The primary goals of the accord were: To make regulatory capital more sensitive to risk Factor off balance sheet exposures into the assessment of capital adequacy Minimize disincentives to holding liquid, low risk assets Achieve greater international consistency in evaluating capital adequacy.

The risk weighted amount is defined as the amount of asset multiplied by specified risk weight assigned. The accord suggested risk weights for varying classes of assets; cash and certain government claims, claims on banks, residential mortgages, other claims and low rated asset backed securities. Off balance sheet exposures are converted into credit equivalent amounts and risk weighted. In 1996, the Basel I framework was revised to incorporate measure for market risk. The measure uses bank internal models to generate capital charges for general market and specific risk. Later in 2005, the committee issued amendments to the market risk measures. The Basel I framework achieved certain notable strengths viz: I. II. III. IV. Regulatory capital definition was clearly defined. It was relatively simple structure Increased the capital ratios of internationally active banks Required capital for off balance sheets exposures.

The accord enhanced competitive equity and enabled comparability of banks capital positions across countries.

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1.9.

BASEL II ACCORD:

The Basel II Accord, the current international framework on capital adequacy was adopted in 1988 by many banks worldwide and in 1992 in India. For the past several years, the Basel committee on Banking Supervision has been working on a new accord to reflect changes in the structure and practices of banking and financial markets. The Basel II was released in a consultative paper in April 2003. The focus has been on strengthening the regulatory capital framework for large and internationally active banks through minimum capital requirement which is more sensitive to the risk profile and risk management. The accord consists of three pillars: Minimum capital requirements Supervisory review Market discipline

FIG 1.6: BASEL II ACCORD

PILLAR I MINIMUM CAPITAL REQUIREMENTS

PILLAR II SUPERVISORY REVIEW

PILLAR III MARKET DISCIPLINE

CREDIT RISK

MARKET RISK

OPERATIONAL RISK

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PILLAR I : MINIMUM CAPITAL REQUIREMENTS : The Basel II accord is based on the concept of a capital ratio where the numerator represents the required amount of capital by a bank and the denominator is the risk weighted assets. The resulting capital adequacy ratio should not be less than 8%. Under the proposed capital accord also, the numerator of the capital ratio remains unchanged at 8%. The modifications have been in the definition contains more focus on risks to make it more meaningful. Measuring of economic capital will be done by aggregation of various risks. The accord covers three types of risks namely, credit risk and market risk. Operational risk a. CREDIT RISK: The methods of measuring credit risk have been given under: standardized approach foundation IRB approach advanced IRB approach in the standardized approach, the risk weights are to be provided to various types of assets according to their risk sensitivity making the capital adequacy more meaningful. It will be based on the external credit assessments or as suggested by the outside reputed rating agencies or other institutions, based on the basis of past experience etc. Whereas in the advanced IRB approach, all the parameters are provided by the banks themselves based on their own estimates. b. MARKET RISK: The standardized approach which specifies the standards in five categories: i. Interest rate risk ii. Equity position risk iii. Foreign exchange risk iv. Commodities risk v. Option risk The second approach to deal in the market risk is based on the internal assessments of the banks. The bank needs to consider the following five elements in calculating the internal model based risk structure.

27

i. ii. iii. iv. v. vi.

General criteria, where the approval from the supervisory authority of the bank is mandatory Qualitative standards regarding the maintenance of the risk management unit Specification of Market Risk Factors Quantitative standards Stress testing to identify the events that could impact the banks. External validation by external auditors and supervisory authorities

c. OPERATIONAL RISK: This risk is defined as the risk of losses resulting from inadequate or failed internal processes, people or systems or from external events. The committee provides that banks need to hold the capital to protect losses arising out of operational risk. This is another area where the regulatory capital approach has been put forth. It contains two simpler approaches to operational risk: the basic indicator approach and the standardized approach.

FIG 1.6: CAPITAL REQUIREMENT UNDER BASEL II ACCORD

REGULATORY CAPITAL

MEASURE OF RISK EXPOSURE

MINIMUM REQUIRED CAPITAL RATIO

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Measure of risk exposure = credit risk exposure + market risk exposure + operational risk exposure.

PILLAR II: SUPERVISORY REVIEW: THE Basel committee has defined the following four basic principles for the supervisory review process: PRINCIPLE I: Banks should have a process for assessing their overall capital adequacy in relation to their risk profile and a strategy for maintaining their capital levels. PRINCIPLE II: the supervisors should review and evaluate banks internal capital adequacy assessments and strategies, as well as their ability to monitor and ensure their compliance with regulatory capital ratios. The supervisors should take an appropriate supervisory action if they are not satisfied with the result of this process. PRINCIPLE III: The supervisors should expect banks to operate above the minimum regulatory capital ratios and should have the ability to require the banks to hold capital in excess of the minimum. PRINCIPLE IV: The supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels required to support the risk characteristics of a particular bank and should require repaid remedial action if capital is not maintained or restored. PILLAR III: MARKET DISCIPLINE: The purpose of the market discipline in the revised frame work is to complement the minimum requirements and the supervisory review process. The aim is to encourage market discipline by developing a set of disclosure requirements which will allow market participants to assess key pieces of information on the scope of application, capital, risk exposures, risk assessment processes and hence the capital adequacy of the institution. In principle, banks disclosures should consistent with how senior management and the board of directors assess and manage the risks of the banks. Non-compliance with the prescribed disclosure requirements would attract a penalty, including financial penalty.

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SUMMARY
POINTS TO REMEMBER: A Commercial bank is a financial intermediary which accepts deposits of money from the public and lends them with a view of making profits. Scheduled banks are included in the second schedule of the RBI act. The central government entered the banking business with the nationalization of the Imperial bank of India in 1955. State bank of India is the largest nationalized bank in india. Electronic banking system has revolutionized the traditional functions of commercial banks. Banks incorporated before the nationalized banks during 1969 and 1980 are known as old private sector banks. The banks which came in operation after 1991are called as new private sector banks. The commercial banks not included in second schedule of the RBI Act are known as non-scheduled banks. Banks where greater parts of stake or equity are held by the private shareholders and not by government are called as the private sector banks. Deposits are the main sources of funds for commercial banks. Savings accounts are opened for the purpose of encouraging the savings habit among the public. Call deposits are accepted from fellow bankers and are repayable on demand. Overdraft is granted against government or other securities, fully paid shares, fixed deposits and etc. A cash credit is a drawing account against a fixed credit limit granted by the bank and is operated exactly in the same manner as a current account with an overdraft facility. A letter of credit is an arrangement by which a buyer enables a seller to get the value of the bill of his supplies effected as per agreed terms. The Narasimham committee recommended reduction in SLR to 25% over the next five years, to enable banks to fund economic activities in a better way.

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 Capital adequacy ratio is a measure of the amount of a banks capital expressed as a percentage of its risk weighted exposures.

QUESTION BANK: SECTION A: 1. 2. 3. 4. 5. 6. 7. 8. What do you mean by public sector banks ? What do you mean by private sector banks ? What do you mean by foreign banks ? What do you mean by regional rural banks and local banks ? What do you mean by demand deposits ? What do you mean by cash credit ? What do you mean by over draft facility ? What do you mean by term loans ?

SECTION B 1. What are the privileges enjoyed by a scheduled banks ? 2. What are the different types of credit facilities available for a customers ? 3. What is capital adequacy ratio? SECTION C: 1. Enumerate the ways in which commercial banks mobilize money from public ? 2. What are the major recommendations of Narasimham Committee report I and II ? 3. Detail the functions of commercial banks ? 4. Detail Basel committee report 5. Detail and describe the banking structure in India.

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UNIT 2 2 2.1 2.1.1 2.1.2 2.2 2.3 2.3.1 2.3.2 2.3.3 2.3.4 2.3.5 2.4 2.4.1 2.5 2.5.1 2.5.2 2.5.3 2.6 2.6.1 2.7 2.7.1 2.7.2 2.7.3 2.7.4 STRUCTURE OF INDIAN BANKING SYSTEM RESERVE BANK OF INDIA ESTABLISHMENT OF THE RBI FUNTIONS OF RBI FACTORS DETERMINING THE LIQUIDITY OF BANKS BASE RATE DEREGULATION OF LENDING RATES AND EMERGANCE OF PRIME LENDING RATES BENCHMARK PRIME LENDING RATE (BPLR) MAJOR ISSUES IN BPLR BASED SYSTEM THE BPLR SYSTEM REPLACED BY THE BASE RATE SYSTEM WHAT IS BASE RATE GOVERNMENT OR GILT EDGED SECURITIES MARKET FEATURES TREASURY BILL FEATURES PARTICIPANTS BENEFITS OF TRESURY BILLS COMMERCIAL PAPER FEATURES CALL MONEY FEATURES BENEFITS FACTORS FOR FLUCTUATION IN CALL MONEY MARKET MEASURES TAKEN BY RBI FOR EFFECTIVE FUNCTIONING OF CALL MONEY MARKET POINTS TO REMEMBER QUESTION BANK

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BANKING STRUCTURE IN INDIA The structure of banking varies widely from country to country. Often a countrys banking structure is a consequence of the regulatory regime to which it is subjected. The banking system in India works under the constraints that go with social control and public ownership. Nationalization for instance, was a structural change in the functioning of commercial banks which was considered to better serve the needs of development of the economy in conformity with national policy and objectives. Similarly to meet the major objectives of banking sector reforms, government stake was reduced up to 51% in public sector banks. Now private sector banks were allowed and foreign banks were permitted additional branches. 2. Structure of Indian banking system Financial sector plays a crucial role in mobilizing community savings into effective investment in a country. Banks are one of the oldest financial intermediaries in financial system. They play an important role in mobilizing of deposits and disbursement of credit to various sectors of the economy. The Indian banking system has the Reserve Bank of India (RBI) at the apex. It is the central bank of the country under which there are Commercial banks including public sector and private sector banks, foreign banks and local area banks. It also includes regional rural banks as well as co-operative banks. The structure of the Indian banking system is given below:

Local Bank s

33

Local Banks

34

2.1. RESERVE BANK OF INDIA Central banks occupy a pivotal position in the monetary and banking structure of a country. It controls the entire banking system of the country. It serves as the leader of the banking and financial system. Reserve Bank of India, the central bank of India, is the apex institution responsible for managing and supervising the activities of the commercial banks in the country. It acts as the central monetary authority and is charged with the duty and responsibility to carry out the monetary policy formulated by the government. 2.1.1 Establishment of the RBI The RBI commenced operations on April 1, 1935 and was nationalized on January 1, 1949. The head office of the bank is in Mumbai and its executive head is called the governor. The objective of establishing the RBI as stated in the preamble to the RBI act 1934 was to regulate the issue of bank notes and keeping of the reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantages 2.1.2 Functions of RBI The reserve bank is the umbrella network for numerous activities all related to the nations financial sector, encompassing and extending beyond the functions of a typical central bank. These are discussed below: i) Issuer of currency RBI is the nations sole note issuing authority, along with the government of India. It is responsible for the design and protection and overall management of the nations currency. With the goal of ensuring and adequate supply of clean and genuine notes, the RBI also makes sure there is an adequate supply of coins produced by the government. The department of currency management in Mumbai, in co-operation with the issue departments in the Reserve Banks regional offices, over sees the production and manages distribution of currency. Currency chests at more than 4000 bank branches typically commercial bankscontains adequate quantity of notes and coins so that currency is accessible to the public in all parts of the country Barring one rupee notes and coins, RBI is the sole authority for the issue of currency in India. The reserve bank has the authority to issue notes up to the value of Rs.10, 000. One rupee notes and coins are issued by the central government. However their distribution to the public is sole responsibility of the RBI.
35

Currency management by the RBI is currency passing through a modernization phase. Number of significant step has been taken in this sphere which includes the following: Building up of the capacity of note printing press. Reforms in the operations of the issue department including in note distribution network. Introduction of new security features. Swift towards higher denomination notes in circulation. a) Printing of currency notes: RBI has 4 printing presses, which actively print notes. Dewas in Madhya Pradesh, Nasik in Maharashtra, Mysore in Karnataka and salbari in west Bengal. Coins are minted by the government of India. RBI is the agent of the government for distribution, issue and handling of coins. 4 mints are in operation: Mumbai, Noida in Uttarpradesh, Kolkata and Hyderabad. b) Clean note policy: The objective of the clean note policy is to withdraw non-issuable notes well in time and put fresh notes in circulation in their place. The clean note policy includes: Education campaign: on preferred way to handle notes: no stapling, writing, excessive folding and the like. Timely removal of solid notes: use of currency verification and processing systems and sorting machines. Exchange facilities: for torn mutilated or defective notes at currency chests of commercial banks and in Reserve Bank issue offices. c) Anti-counterfeiting measures: The security features of bank notes are reviewed and updated from time to time, taking advantage of the research and technology in the field. The approach has been to improve the security features in the existing design so as to combat counterfeiting and to incorporate a mixture of security features on a completely new series of notes. Anti-counterfeiting measures are: Continual upgrades of bank note security features. Public awareness campaigns to educate citizens to help prevent circulation of forged or counterfeit notes. Installation of note sorting machines. Given the volume involved and cost incurred in printing, transport, shortage and removal of unfit / soiled notes. Reserve Bank is evaluating ways to extend the life of bank

36

notes particularly in the lower denominations. For example, Reserve Bank is considering issues of Rs.10 notes in polymer. d. Confiscation of lower denomination of notes: The circulation of currency in India has increased phenomenally both in volume and value terms. As part of currency management, it has been the endeavor of the RBI to contain the volume of notes in circulation by confiscation of lower denomination notes and a conscious shift towards higher denomination notes in circulation. ii) Banker and debt manager to the government Before the formation of the RBI, the imperial bank of India performed many of the functions as banker to the government. With the establishment of the RBI, the imperial banks ceased to be the banker to the government, but entered into an agreement with the RBI for providing its service as the sole agent of the RBI in places where it had no branch of the banking department of the RBI. The role as banker and debt manager to government includes several distinct functions: Undertaking banking transactions for the central and state governments to facilitate receipts and payments and maintaining their accounts. Managing the governments domestic debt with the objective of raising the required amount of public debt in a cost-effective and timely manner. Developing the market for government securities to enable the government to raise debt at reasonable cost, provide benchmarks for raising resources by other entities and facilitate transmission of monetary policy action. Managing the governments banking transactions is a key role of Reserve Bank of India. Like individuals, business and banks governments need a banker to carry out their financial transactions in an efficient manner, including the raising of resources from the public. Presently, RBI is the banker for all government in India (except Jammu and Kashmir). The RBI provides all those banking service to the central and state governments which a commercial bank ordinarily offers to its customers. As a banker to the central government, the Reserve Bank maintains its accounts, receives money into and makes payments out of these accounts and facilitates the transfer of government funds. It is the duty of the finance department of each government to ensure that there are always sufficient funds in its bank account (minimum balance) Another function of the RBI as the governments banker is the management of public debt. The RBI manages all new issue of government loans, servicing the public debt outstanding and prepares the market for government securities. Also, the RBI acts as

37

advisor to the government on such matters as international finance, banking legislation, and resources for 5 year plans. In its role as governments debt manager, RBI sets policies in consultation with government and determines operational aspects of raising money to help the government finance its requirements. Determines the size, tenure and nature (floating or fixed rate) of the loan. Define the issuing process including holding of actions. Inform the public and potential investors about upcoming government loan actions. The RBI also undertakes market development efforts, including enhanced secondary market trading and settlement mechanisms, authorization of providing dealers and improved transparency or issuing process to increase investor confidence with the objective of broadening and deepening the government securities market. iii) Banker to banks Like individual customers, business and organization of all kinds, banks need their own mechanisms to transfer funds and settle inter-bank transactions such as borrowing from and lending to other banks and customer transaction. As the banker to banks, the RBI fulfills this role. In effect, all banks operating in the country have accounts with the Reserve Bank, just as individuals and business have accounts with their banks. As the banker to banks, RBI focuses on: Enabling smooth, swift and seamless, clearing and settlement of interbank obligations. Providing an efficient means of funds transfer for banks. Enabling banks to maintain their accounts for the purpose of statutory reserve requirements and maintaining transaction balance. Acting as lender of the last resort. The RBIs responsibility as bankers bank was essential two fold. First, it acts as a source or resource to the banking system, especially for meeting the seasonal requirement apart from serving as the lender of last resort, most in times of emergency. The second responsibility was to ensure that the banks were established and run on sound lines, the emphasis in those years being mainly on the protection of depositors interest rather than on credit regulations. Under the Reserve Bank of India Act, 1934 and the Banking regulation Act 1949 the RBI vested with extensive powers of supervision regulation and control over commercial and co-operative banks. The regulatory functions of the RBI pertain to licensing branch

38

expansion and amalgamation of commercial banks. The RBI calls for returns and other information from the commercial banks and periodically inspects their workings.

iv) Controller of Monetary Authority Like other Central banks the core functions of the RBI is to formulate and administer monetary policy to maintain the stability of the rupee. Monetary policy refers to the use of instruments under the control of the Central bank to regulate the availability, cost and use of money and credit. The main objectives of monetary policy in India are: Maintaining price stability Ensuring adequate flow of credit to the productive sectors of the economy to support economic growth. Financial stability The relative emphasis among the objectives varies from time to time depending on evolving macro economic developments. The operating framework is based on a multiple indicator approach. This means that Reserve Bank monitor and analyze the movement of a number of indicators including interest rates, inflation rate, money supply, credit, exchange rate, trade, capital flows and fiscal position along with trends in output, while developing policy perspectives. a) Direct Instruments 1. Cash Reserve Ratio (CRR): The share of net demand and time liabilities that banks must maintain as cash balance with the Reserve Bank. The Reserve Bank requires bank to maintain a certain amount of cash in reserve as a percentage of their deposit to ensure that banks have sufficient cash to cover customer withdrawals. Increase / decrease in CRR are used by the RBI as an instrument of monetary control particularly to mop up excess increase in supply of money. This power was given to RBI in 1956. This investment does not carry any interest. CRR is a regulatory tool for RBI to achieve desirable policy outcome. There is a debate going on between the RBI and other stakeholders to do away with it or it should at least pay interest on CRR since banks pay their depositors. If CRR is phased out, this would allow banks to lower lending rates, helping industry. It is argued that since RBI does not pay any interest on CRR, this act has a tax on the banking system and places them at competitive disadvantage vis--vis finance companies and mutual funds. 2. Statutory liquidity Ratio (SLR): Apart from the CRR, banks in India are also subject to statutory liquidity requirement. Under this requirement Commercial Banks along with other financial institution like LlC, GIC and the Provident Fund institution are
39

required under law to invest prescribed minimum proportions of their total asset / liabilities in Government securities and other approved securities. The underlying philosophy of this provision is to allocate total bank credit between the Government and the rest to the economy. The SLR provision has created an active market for Government securities which increases automatically with the growth in the liabilities of the banks. Moreover, it has kept the cost of the debt to the Government low in view of the generally low rate of interest on government securities. 3. Refinance facilities: sector specific refinance facilities (e.g., against lending to export sector) is provided to banks. b) Indirect Instruments 1. Liquidity Adjustment Facility (LAF): Consists of daily infusion or absorption of liquidity on a repurchase basic, through repo (liquidity injection) and reverse repo (liquidity absorption) auction operations against government securities as collateral. 2. Open Market Operations (OMO): Out right sales / purchases of government securities in addition to LAF, as a tool to determine the level of liquidity over the medium terms. The RBI can enter the money market for the purpose of purchase or sale of Government securities on its own account. Every open market purchase by the RBI increase primary money by equal amount while every sale decreases it. As regards this advantage, open market operations are highly flexible, easily reversible in time, their effect on money supply is immediate and they do not carry announcement effects as in the case of changes in bank rate. 3. Market stabilization scheme (MSS): This instrument for monetary policy was introduced in 2004, Liquidity of a more enduring nature arising from large capital flows is absorbed through sale of short - dated government securities and treasury bills. The mobilized cash is held in a separate government account with the Reserve Bank. 4. Repo / reverse repo rate: These rates under the Liquidity adjustment facility (LAF) determine the corridor for short term money market interest rates. In turn, this is expected to trigger movement in other segments of the financial market and the real economy. A transaction in which two parties agree to sell and repurchase the same security is known as ready forward contract or Repos or buyback deal. This arrangement provides for the seller to sell specified securities with an agreement to repurchase the same at a mutually predetermined future date and price, and the buyer to purchase the securities with an agreement to resell the same to the seller at a predetermined future date and price. A reverse repo is the opposite of a repo transaction. It is born in the Reverse Repurchase Agreement. Under this arrangement, the counter party enters into a
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reverse repurchase agreement and makes a short-term collateralized loan to the bank, the primary dealer or the seller of securities. This is done by providing funds in return for holding securities. On the maturity of the reverse repurchase transaction, the counter party returns the same security to the same bank, the primary dealer and receives back the funds from the buyer. The amount that is received by the buyer is the principal plus the interest, the interest being generally termed as the Repo rate. This arrangement allows banks to make efficient use of their funds. The repo and reverse repos market is dominated by the major players the banks, who hold substantially huge portfolios of tradable Government securities. An active institutional player in the Repo market is the DFHI that trades on repo basis, Treasury Bills and eligible dated Government of India Securities. Besides, the institution is also providing liquidity support against the collateral of Government securities by way of repo transaction. 5. Bank rate: The RBI provides credit to banks by rediscount eligible bills of exchange, and by making advances against eligible securities such as Government securities, Commercial Papers etc., It is the rate at which the Reserve Bank is ready to buy or rediscount bills of exchange or other commercial papers is called the Bank rate, which is a traditional weapon to control money supply. An increase in the bank rate would discourage Commercial Banks to borrow from the RBI and a corresponding increase in the lending rate of Commercial Banks to general public would decrease public borrowing from the banks. 6. Moral Suasions: Through moral suasion (discussion, suggestion and advice) the RBI can influence the investment and credit policies of the Commercial Banks. For example it can ask the Commercial banks to invest a proportion then required of their assets in Government securities. Similarly it can advise them regarding the allocation of credit to the private sector. 7. Marginal Standing Facility: Scheduled Commercial Banks can borrow over night at their discretion up to one per cent of their respective NDTL at 100 basis points above the repo rate to provide a safety value against unanticipated liquidity shocks. v) Regulator of the Banking System Banks are fundamental to the nation's financial system. The central bank has a critical role to play in ensuring the safety and soundness of the banking system and in maintaining financial stability and public compliance in this system. As the regulator and supervisor of the banking system, the Reserve Bank protects the interests of depositors, ensures a framework for orderly development and conduct of banking operations conducive to consumer interests and maintain overall financial stability through preventive
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and corrective measures. For this, different departments of the Reserve Bank Oversees the various entries that comprise Indian's financial infrastructure. 1. Commercial Banks and All India development financial Institution: Regulated by the Department of Banking operations and Development, supervised by the Department of Banking supervision. 2. Urban Co-operative Banks: Regulated and supervised by the Urban Banks Department. 3. Regional Rural Banks, District Central Co-operative Banks and State Cooperative Banks. Regulated by the Rural planning and Credit Department and supervised by NABARD. 4. Non Banking Financial companies (NBFCs) Regulated and supervised by the Department of Non Banking supervision. The Reserve Bank makes use of several supervisory tools, such as: Onsite inspections, Offsite surveillance, making use of required reporting by regulated entries and thematic inspections, scrutiny and periodic meeting. The Board for Financial Supervision Oversees the Reserve Banks regulatory and supervisory responsibilities. As the nations financial regulator the Reserve Bank handles a range of activities, including: 1. Licensing 2. Prescribing capital requirements 3. Monitoring governance 4. Setting prudential regulations and ensure solvency and liquidity of the banks 5. Prescribing lending to certain priority sectors of the economy 6. Regulating interest rates in specific areas 7. Setting appropriate regulatory norms related to income recognition, asset 8. Classification, provisioning, investment valuation, exposure limit and the like 9. Initiating new regulations vi) Manager of Foreign Exchange In recent years, with increasing integration of the Indian economy with the global economy arising from greater trade and capital flows, the foreign exchange market has evolved as a key segment of the Indians financial market. The RBI is the custodian of the foreign exchange reserves of India. The Reserve Bank plays a key role in the regulation and
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development of the foreign exchange market and assumes three broad roles relating to foreign exchange. 1. Regulating transactions related to the external sector and facilitating the development of the foreign exchange market. 2. Ensuring smooth conduct and orderly conditions in the domestic foreign exchange market. 3. Managing the foreign currency assets and gold reserves of the country. vii) Regulator and Supervisor of payment and settlement system Payment and settlement systems play an important role in improving overall economic efficiency They consists of all the diverse arrangements that use to systematically transfer money - currency, paper instrument such as cheques and various electronic channels. The Payment and Settlement System Act of 2007 (PSS Act) gives the Reserve Bank oversight authority, including regulation and supervision, for the payment and settlement system is the country. In this role, Reserve Bank focuses on the development and functioning of safe, secure and efficient payment and settlement mechanisms. Efficient funds' clearing was first introduced in the 80s through magnetic ink Character recognition (MICR) technology 1. Retail Payment System: Facilitating cheque clearing, electronic fund transfer, through National Electronic Funds Transfer (NEFT) settlement of card payments and bulk payments, such as electronic clearing services. Operated through local clearing houses throughout the country. 2. Large value system: Facilitating settlement of inter-bank transactions from financial markets. These include: a) Real Time Gross settlement system (RTGs): for funds transfers. b) Securities Settlement System: for the Government securities market. c) Foreign exchange clearing: for transactions involving foreign currency. viii) Developmental Role Apart from performing the customary functions of a Central Bank, the RBI has played an important role in building, consolidating and strengthening the financial infrastructure of India. This includes ensuring that credit is available to the productive sector of the economy, establishing institutions designed to build the countries financials infrastructure, expanding access to affordable financial services and promoting financial education and literacy. Over the years, the Reserve Bank has added new institutions as the economy has evolved. Some of the institutions established by RBI include:

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1. Deposit Insurance and Credit Guarantee Corporation (1962) to provide protection to bank depositors and guarantee cover to credit facilities extended to certain categories of small borrowers. 2. Unit Trust of India (1964) the first Mutual Fund of the Country. 3. Industrial Development Bank of India (1964) a development finance institution for Industry. 4. National Bank for Agriculture and Rural Development (1982) for promoting rural and agriculture credit. 5. Discount and Finance House of India (1988) a money market intermediary and a primary dealer in Government securities. 6. National Housing Bank (1989) an apex financial institution for promoting and regulating housing finances. 7. Securities and Trading Corporation of India (1994) a primary dealer. ix) Research Data and Knowledge Sharing: The Reserve Bank has a rich tradition of generating sound, policy-oriented economic research, data compilation and knowledge sharing. The research work is designed to: 1. Educate the public. 2. Provide reliable, data driven information for policy and decision making. 3. Supply accurate and timely data for academic research as well as to the general Public. x) Commutating with the Public: This involves a range of activities, all aimed at sharing knowledge about the financial arena. The Reserve Banks website provides a full range of information about the banks activities and publications. The website is updated regularly and is posted in its local languages. 2.2 FACTORS DETERMINING LIQUIDITY OF BANKS The liquidity of a bank is determined by the top management of the bank, depending up on the nature of the business conditions in a country. The central bank also has the power to determine liquidity of a bank. The amount of liquid assets which banks maintain depends upon many factors. 1. Liquidity Reserve: The size of liquid reserves will depend upon the extent of liquid reserves considered essential by the banking community. This is either embodied in the form of a law or it is enforced through convention. 2. Banking habits: The size of liquid reserves will depend upon the banking habits of people. This in turn, depends upon the nature of the economy, in advanced economy people have the cheque habits and therefore the use of cash is considerably reduced.
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On the other hand, in a developing economy, banking habits are not fully developed and hence the cheque system is not commonly used. Besides, even the slightest rumors upset the people who rush to banks to withdraw their deposits. In such conditions, the banks are forced to maintain large liquid reserves. 3. Monetary policy: The size of liquid reserves will depend upon the number and magnitude of monetary transactions in the country. During busy seasons (for example: harvest season in India or Christmas season in the western countries) banks will be called upon to finance a large number of transactions and hence have to keep a large percent of cash. 4. Structure of Banks: Liquidity is determined by the structure of the banking system. Under the branch banking system, the cash reserves can be centralized in the head office and branches can manage with smaller portion of cash reserves. In the unit banking system, however every bank is an independent unit and has to keep a higher degree of liquidity. 5. Money Market: If the money market is well organized, it will be easy for banks to buy and sell securities easily, it is particularly important. In such case, a commercial bank can afford to have a large percentage of government securities in its portfolio and keep smaller volume of cash.

2.3 BASE RATE Consistent with the objective of providing credit to the productive sectors of the economy, the lending rates as well as the allocation of bank credit, was by and large, regulated by the Reserve Bank till the late 1980s. Further , there were numerous sector-specific , programme -specific and purpose-specific credit stipulations provided from time to time. Initial attempt to rationalize the administered lending rate structure was made in September 1990 by removing multiplicity and complexity of interest rate. 2.3.1. Deregulation of lending rates and emergence of Prime Lending Rates (PLR) After the initiation of financial sector reforms in the early 1990s, various steps were initiated to deregulate the lending rates of commercial banks. The credit limit of scheduled commercial banks, on which administered rates were prescribed, was reduced into three slabs in April 1993. The slabs or credit limit under the revised guidelines consisted of three categories: (i) (ii) (iii) Advances up to and inclusive of Rs.25,000. Advances over Rs.25,000 and up to Rs.2,00,000. Advances over Rs.2,00,000.
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In a major step towards deregulation of lending rates, it was decided in October 1994 that banks would determine their own lending rates for credit limits over Rs.2,00,000 in accordance with their risk-reward perception and commercial judgment .Banks were at the same time required to declare their Prime Lending Rates (PLR), the rate charges for the prime borrowers of the bank, with the approval of their boards taking into account their cost of funds, transaction costs, etc., 2.3.2. Benchmark Prime Lending Rate (BPLR) With aim of introducing transparency and ensuring appropriate pricing of loans the Reserve Bank advised banks to announce a benchmark PLR (BPLR) with the approval of their boards. The BPLR was seen as a reference rate and was to be computed taking into consideration (i) cost of funds; (ii) operational expenses; and (iii) a minimum margin to cover regulatory requirements of provisioning and capital charge, and profit margin. Benchmark prime Lending Rate (BPLR) is the interest rate that Commercial Banks normally charge (expect to charge) their creditworthy customers. The system of benchmark Prime Lending Rate (BPLR) introduced in 2003 was expected to serve as a benchmark rate for banks pricing of their loan products so as to ensure that it truly reflected the actual cost. However, the BPLR system fell short of its original objective of bringing transparency to lending rates. This was mainly because under the BPLR system, Banks could lend below the BPLR. For the same reason, it was difficult to assess the transmission of policy rates of the Reserve Bank to lending rates of Banks. Table 1:Evolution of BPLR in India : A snapshot October 1994 Lending rates for loans with credit limits of over Rs.2,00,000 deregulated. Banks were required to declare their prime lending rates (PLR). February 1997 Banks allowed prescribing separate PLRs and spreading over PLRs, both for loan and cash credit components. October 1997 April 1998 April 1999 October 1999 For term loan of 3 years and above, separate prime term lending rates (PTLRs) were required to be announced by banks. PLR converted as a ceiling rate on loans up to Rs.2,00,000. Tenor-linked prime lending rates (TPLRs) introduced. Banks were given flexibility to charge interest rates without reference to the PLR in respect of certain categories of loans / credit.

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April 2000 April 2003

The PLR ceased to be the floor rate for loans above Rs.2,00,000. Commercial banks allowed lending at sub-PLR rate for loans above Rs.2,00,000. The Reserve Bank advised banks to announce a Benchmark Prime Lending Rate (BPLR) with the approval of their boards. The system of tenor-linked PLR discontinued.

2.3.3. Major issues in the BPLR based system The BPLR system was expected to be a step forward from the PLR system, which more or less represented the minimum lending rates to that of one which stood as a benchmark or a reference rate around which most of the banks lending was expected to take place. However, over a period of time, several concerns have been raised about the way the BPLR system has evolved. 1. Extent of sub-BPLR lending Following the permission given for sub-BPLR lending, banks were permitted to offer subBPLR rates to exporters and other creditworthy borrowers, including public sector enterprises on the lines of a transparent objective policy approved by their respective boards. However, over the years, because of competitive pressures banks have increasingly resorted to financing of various categories of borrowers at sub-BPLR rates such as corporates, housing and retail sector. 2. Lack of transparency Higher levels of transparency can be achieved by disclosing important information on loan pricing and possible fees to the borrower before he/she signs the agreement. It should be ensured that all charges and possibility of increases are made clear to the borrower at the beginning of the agreement. The existence of a benchmark rate, to which the various loans are tied to, is a crucial component in attaining transparency in loan pricing. Given the large proportion of sub-BPLR lending by the banking system, concerns have been raised on the transparency aspect of computation of BPLRs by banks. 3. Downward stickiness of BPLRs Another issue that is often raised is the asymmetric downward stickiness of the BPLRs. For instance, during the monetary policy-tightening phase (March 2004 to September 2008), it has been observed that while banks were often quick in raising lending rates during an upturn in the interest rate cycle, they were slow to bring down the interest rate cycle. 4. Cross-subsidization in lending
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Sub-BPLR lending on a large scale has created a perception that large borrowers are being cross-subsidized by retail and small borrowers. 2.3.4. The BPLR system be replaced by the base rate system In order to address these concerns, the Reserve Bank announced the constitution of the Working Group (Chairman: Shri Deepak Mohanty) on Benchmark Prime Lending Rate (BPLR) in the annual policy statement of 2009-10 to review the BPLR system and suggest changes to make credit pricing more transparent. The working group submitted its report on October 20, 2009. Based on the recommendations of the group and the suggestions from various stakeholders, the Reserve Bank issued the guidelines on the Base Rate system on April 9, 2010. Accordingly, the system of base rate came into effect since July 1, 2010. 2.3.5. What is base rate? The Base Rate is the minimum interest rate of a bank below which it cannot lend, except for *Differential Rate of Interest (DRI) advances, *loans to banks own employees, and *loans to banks depositors against their own deposits (i.e. cases allowed by RBI). Base Rate is to be reviewed by the respective banks at least on quarterly basis and the same is to be disclosed publicly. Methodology for computation of Base Rate Base Rate = a + b + c + d a = Cost of deposits / funds (benchmark) b = Negative carry on CRR and SLR c = Unallocatable Overhead Cost d = Average Return on Net Worth. 2.4 GOVERNMENT OR GILT-EDGED SECURITIES MARKET The marketable debt issued by the government or semi-government bodies, which represents a claim on the Government, is known as a Government security or Gilt-edged security.

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2.4.1 FEATURES: Following are the characteristics of a Government securities\market, which plays a significant role in the Indian stock market: 1. Agencies: Government securities are issued by agencies such as Central Government, State Governments, semi-government authorities like local Government authorities, e.g. municipalities, autonomous institutions such as metropolitan authorities, port trusts, state electricity boards, Public Sector Enterprises, and other Governmental agencies like IDBI, IFCI, SFCS, NABARD, LDBS, SIDCs, housing boards etc. The demand essentially emanates from banks, financial institutions and other investors. 2. RBIs special role: RBI takes a special and an active role in the purchase and sale of these securities as part of its monetary management exercise. The brokers and dealers including banks approved by the RBI are eligible to deal in these securities. 3. Nature of securities: Securities offer a safe avenue of investment through guaranteed payment of interest and repayment of principal by the government. They offer relatively a lower fixed rate of interest compared to interest rate on other securities. They are issued in the denominations of Rs.100 and Rs.1000. They have a fixed maturity spanning a period of time. 4. Liquidity profile: The liquidity profile of gilt-edged securities varies. Accordingly liquidity profile of securities issued by Central Government is high. However, the securities issued by State governments local Government organizations have limited liquidity. 5. Tax rebate: A striking feature of these securities is that they offer wide-ranging tax incentives to investors. This has made these securities very popular. Rebates for investment in these securities are available under the Income Tax and other Acts. 6. Market: As each sale and purchase has to be negotiated separately, the gilt-edged market is an over-the-counter market. The Government securities market in India has two segments namely primary market and secondary market. The issuers such as Central Government and state governments constitute the primary market. The secondary market comprises banks, financial institutions, insurance companies, provident funds, trusts, individuals, primary dealers and Reverse Bank of India. 7. Forms: The securities of Central and State Government take such forms as inscribed stock or stock certificate, promissory note and bearer bond.

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8. Price basis: The auctions for issue of securities will be held either on uniform price method or multiple price method or any other method decided by the Government of India or the RBI in consultation with the Government of India.

2.5. TREASURY BILL A kind of finance bills, which are in the nature of promissory notes, issued by the government under discount for a fixed period, not exceeding one year, containing a promise to pay the amount stated there in to the bearer of the instrument, are known as treasury bills. A market for the purchase and sale of treasury bills is known as a Treasury Bills Market. 2.5.1 FEATURES: Treasury bills incorporate the following general features: 1. Issuer: TBs are issued by the government for raising short-term funds from institutions or the public for bridging temporary gaps between receipts (both revenue and capital) and expenditure. 2. Finance bills: TBs are in the nature of finance bills because they do not arise due to any genuine commercial transaction in goods. 3. Liquidity: TBs are not self liquidating like genuine trade bills, although they enjoy higher degree of liquidity. 4. Vital source: Treasury bills are an important source of raising short-term funds by the government. 5. Monetary management: TBs serve as an important tool of monetary management used by the central bank of the country to infuse liquidity in to the economy. 2.5.2 PARTICIPANTS: The participants in the TBs market include the RBI, the State Bank of India, Commercial Banks, State Governments and other approved bodies, Discount and Finance House of India as a market maker in TBs, the Securities Trading Corporation of India (STCI), other financial institutions such as, LIC, UTI, GIC, NABARD, IDBI, IFCI, ICICI, etc corporate entities and general public and foreign Institutional Investors. Of the above mentioned participants, RBI and commercial banks are the most popular players. This essentially arises from the nature of relationship between them. TBs are least popular among the corporate entities and the general public. 2.5.3 BENEFITS OF TREASURY BILLS:
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TBs being an important money market instruments provide the following benefits: 1. Liquidity: Treasury bills command high liquidity. A number of institutions such as RBI, the DFHI, STCI, commercial banks, etc take part in the TB market. In addition, the central bank is always prepared to purchase or discount TBs. 2. No default risk: Since there is a guarantee by the central government, TBs are absolutely free from the risk of default of payment by the issuer. Moreover, the government itself issues the TBs. 3. Availability: RBI has the policy of making available on a steady basis, the TBs especially through the Tap route since July 12, 1965. This greatly helps banks and other institutions to park their funds temporarily in TBs. 4. Low cost: Trading in TBs involves less transaction costs. This is because two-way quotes with a fine margin are offered by the DFHI on a daily basis. 5. Safe return: The biggest advantage of TBs is that they offer a steady and safe return to investors. There are not many fluctuations in the discount rate. It is also possible for the investors to earn attractive return by keeping investment in nonearning cash to the minimum and supplementing it with TBs. 6. No capital depreciation: Since TBs command high order of liquidity, safety and yield, there is very little scope for capital depreciation in them. 7. SLR eligibility: TBs are of great attraction to commercial banks as it helps them park their funds (Net Demand and Time Liabilities) as per the norms of SLR announced by the RBI from time to time. This reason makes commercial banks dominant dealers in TBs. 8. Funds mobilization: TBs are used as an ideal tool by the government for raising short-term funds required for meeting temporary budget deficit. 9. Monetary management: It is also possible for the government to mop up excess liquidity in the economy through the issue of TBs. Since TBs are subscribed by the investors other than the RBI, the issue would neither lead to inflationary pressure nor result in monetization. 10. Better spread: TBs facilitate proper spread of asset mix with different maturity as they are available on top basis as well as in fortnightly auctions. 11. Perfect hedge: TBs can be used as a hedge against volatility of call loan market and interest rate fluctuations. 12. Fund management: TBs serve as effective tools of fund management because of the following reasons: Ready market availability, both for sale and purchase at market driven prices, thus imparting flexibility. Facility of rediscounting TBs on tap basis.
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 Facility of refinancing from the RBI. Plethora of options available to fund managers to invest in TBs and for raising funds against TBs especially through and with the help of DFHI. Ideally suited for investment of temporary surplus. Possibility of building up portfolio of TBs with dates of maturities matching the dates of payment of liabilities, such as certificates of deposits and deposits of short-term maturities. Possibility of meeting the temporary difficulties of funds by entering into buyback transactions for surplus TBs and reversing the transactions when the financial need is over. Possibility of making enhanced profit by indulging in quick raising of money against TBs for investing in call money market when call rates are high and doing the reverse when call rates dip.

2.6. COMMERCIAL PAPER Debt instruments that are issued by corporate houses for raising short-term financial resources from the money market are called Commercial Papers (CPs). 2.6.1 FEATURES: Following are the features of commercial papers: 1. Nature: These are unsecured debts of corporate which are issued in the form of promissory notes and are redeemable at par to the holder at maturity. CPs are issued at a discount to face value in multiples of Rs.5lakhs. CPs attract stamp duty. No prior approval of RBI is needed to issue CPs and no underwriting is mandatory. The issuing company should have a minimum tangible net worth to the extent of Rs.4crores. Moreover, the working capital limit of the company should not be less than Rs.4crores and this allows corporates to issue CPs up to 100 percent of their fund based working capital limits. The issuing company has to bear all expenses (such as dealers fees, rating agency fee and charges for provision of stand-by facilities) relating to the issue of CP. The issue of Cps serves the purpose of releasing the pressure on bank funds for small and medium sized borrowers, besides allowing highly rated companies to borrow directly from the market.

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2. Market: The market for the CPs comprises of issues made by public sector and private sector enterprises. CPs issued by top rated corporates are considered as sound investments. Conditions attached to the issue are less stringent than those applicable for raising CPs. Beginning from September 1996, Primary Dealers (PDS) were also permitted by RBI to issue CPs for augmenting their resources. This is one of the steps initiated by the RBI to make the CPs market popular. 3. Rating: As per the guidelines of the RBI, CPs are required to be graded by the organization issuing them. Accordingly, a rated CP is considered to be a quality and sound instrument. With the liberalization of interest rate structure, the rate of interest is market-determined. This causes wide variation in the prevailing rates of interest. 4. Interest rates: The rate of interest applicable to CPs varies greatly. This variation is influenced by a large number of factors such as credit rating of the instrument, economic phase, the prevailing rate of interest in CPs market, call rates, the position in foreign exchange market, etc. It is however to be noted that there is no benchmark for interest rate. 5. Marketability: The marketability of the CPs influenced by the prevailing in the call money market and the foreign exchange market. Accordingly where attractive interest rates prevail in these markets, the demand for CPs will be affected. This is because, investors will divert their investment into these markets. 6. Maturity: The minimum maturity of CP has been brought down from 3 months 30 days and was further reduced to 15 days with effect from May 25, 1998. This was done with a view to encouraging issuance of CPs 7. Cps in lieu of W.C: The nature of credit policy announced by the RBI allows highly rated corporates to have the advantage of banks offering an automatic restoration of working capital limits on the repayment of CP. Accordingly, short-term working capital loans were substituted with cheaper CPs. This was done by the RBI to hasten the growth of the CP market. 2.7. CALL MONEY Call funds include very short-period funds such as money-at-call and short-notice, etc. A market where call funds are borrowed and lent is called Call Money Market. 2.7.1. FEATURES: Call Money Market has the following features: 1. Call and notice money: Call money market deals in very short period funds called call funds/money. The period ranges from overnight to a fortnight. Whereas Call Money
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is repayable on the immediate next working day, notice money is repayable within a fortnight. These transactions are not covered by any collateral security. This is because, call loans are repayable on demand at the option of the borrower or lender or at a very short notice. This makes call loans very liquid, next only to cash. 2. Sensitive segment: Call money market is the most sensitive segment of the financial system this is because, any change in demand and supply of short-term funds in the financial system is quickly reflected in call money rates. The central bank of the country makes use of this market for conducting the open market operations efficiently. 2.7.2. BENEFITS: Call money market offers the following benefits to commercial banks: 1. Quick funds: Call money market offers the advantage of easy and quick borrowing to meet the statutory liquidity requirement of banks. 2. Best investment: Call money market facilitates effective and profitable investment of temporary surplus funds. Further, the market provides the assurance of excellent liquidity of funds invested. 3. Profitability: Banks invest their surplus funds in a period when call rates are high and volatile, and maximize their profits through call money operations. 2.7.3. FACTORS FOR FLUCTUATIONS IN CALL MONEY RATE: The rate of interest on call funds is called call money rate. Call money rates are characteristic in that they are found to be having seasonal and daily variations requiring intervention by RBI and other institutions. A striking feature of the Indian call money market has been the wide and varying fluctuations noticed in the call rates due to many factors. Some of these factors are outlined below: a) CRR requirement: The CRR (Cash Reserve Ratio) is an important tool with the RBI. This is often used for influencing liquidity in the financial system. Heavy rush, followed by large borrowings by banks on mandatory reporting Fridays in order to meet the CRR requirements, causes rise in demand for liquid resources. This consequently leads to rise in call rates. Call rates, however, show a declining tendency once the CRR requirement is met. Conversely, call rates tend to go up where banks make huge demand for liquid resources for meeting structural disequilibria in their inflows and outflows of funds. b) Institutional selling: Call rates tend to go up when institutional lenders who are short of liquidity, start selling securities for meeting their loan repayment or
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c)

d)

e)

f)

g)

h)

i)

maturity of their instruments or other business needs. This causes a sudden spurt in demand for call funds. Corporate demand: When advance taxes are payable by companies and other institutions, during a particular part of the year, viz., the quarter-ends, demand for funds also go up causing a spurt in call rates. Bank deposits: Where banks are flush with more deposit funds, supply of call funds increases which eventually causes decrease in call rates. Similarly, call rates go down where banks are under the situation of having to immediately honor the deposit obligation. Stock market: The stock market conditions largely cause wide fluctuations in the call rates. For instance, when the stock market is buoyant, call rates go up and vice versa. Similarly, during industrial and commercial boom, call rates move up and cause a decline in the period of depression. GSMs vagaries: The conditions prevailing in the Government Securities Market (GSM) also influences the call rates. For instance, when subscription to government loans opens, the demand for call loans go up, thus spurting call rates. Conversely, supply of funds increases and calls rates decrease as government securities nature. A jump in the liquidity resources of banks due to interest payments on central and state government securities in the months of April, May, October, and November has a definite effect on the call rates. Alternative source: The demand for call funds is also influenced by the alternative sources of short-term funds that are available for banks. For instance, where it is possible for banks to avail the liberal access to rediscounting or refinance facility from the RBI at cheaper interest rates, the demand for call funds decrease causing decline in call rates. Cyclical fluctuation: The demand and the supply of call funds is greatly determined by the quality of business conditions. For instance, during the busy season from October to March, there is a greater demand for call loans and the demand is less during the slack season from April to September. In the same manner, a bank dealing in international trade transactions may find itself in a less-liquidity situation on account of its pressing commitments for meeting bulk import payments during a certain part of the year. Other causes: In addition to the addition to the above causes, following are some of the other factors that cause call rate volatility. 1. Absence of adequate number of big lenders thus causing liquidity crunch and enhanced call rates. 2. Lack of sophisticated statistical techniques for forecasting call rates for application by fund managers in India resulting in a situation of overreaction to changes in the call market.

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3. Highly telephone-dependent nature of the call market, creating the problem of varied rates at various places owing to the absence of perfect communication network(the problem is sought to be eased with the setting up of DFHI) 2.7.4. MEASURES TAKEN BY RBI FOR EFFECTIVE FUNCTIONING OF CALL MONEY MARKET: There is an imperative need for keeping the call market happenings steady and stable. Allowing call rates to be volatile causes a lot of damage to the orderly development of the money market, which is an essential perquisite for an efficient financial system. In the light of the above, the RBI has taken a number of measures as described below, towards reducing the call rate volatility. 1. More participants: RBI has allowed the entry of large number of participants thus spurring competition. This has helped broad base the market. 2. New instruments: Efforts were also initiated to introduce new money market instrument. 3. New institutions: RBI also took steps in the setting up of DFHI as market maker and STCI for trading in securities. The STCI introduced reference call money rate on a daily basis to be published after the trading hours beginning from October 1, 1997. 4. Direct role: RBI has undertaken a number of direct measures such as occasional intervention in the event of call rate volatility, by providing refinance facility to banks so as to enhance the liquidity position and advice to commercial banks against using call funds for normal banking operations thus causing unnecessary spurt in call money rate. RBI also introduced flexible interest rate structure in banks for the purpose of easing the liquidity position. 5. Non-bank entities: RBI gave permission to non-bank entities to lend in the call money market by routing their call money operations through primary dealers with a view to increasing supply of liquidity money market, beginning from April 1999. 6. IBCMM: Efforts are continued to be made by the RBI to work towards accomplishing the pure Interbank Call Money Market (IBCMM) as per the suggestions of the Narasimham Committee II.

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POINTS TO REMEMBER 1. The RBI commenced operations on April 1, 1935. 2. The RBI was nationalized on January 1, 1949. 3. Before the formation of the RBI, the imperial bank of India performed many of the functions as banker to the government. 4. Barring one rupee notes and coins, RBI is the sole authority for the issue of currency in India. 5. CRR is the share of net demand and time liabilities that banks must maintain as cash balance with the Reserve Bank. 6. Under the SLR requirement Commercial Banks along with other financial institution like LlC, GIC and the Provident Fund institution are required under law to invest prescribed minimum proportions of their total asset / liabilities in Government securities and other approved securities. 7. A transaction in which two parties agree to sell and repurchase the same security is known as ready forward contract or Repos or buyback deal. 8. Bank Rate is the rate at which the Reserve Bank is ready to buy or rediscount bills of exchange or other commercial papers. 9. Deposit Insurance and Credit Guarantee Corporation (1962) was established to provide protection to bank depositors and guarantee cover to credit facilities extended to certain categories of small borrowers. 10. National Bank for Agriculture and Rural Development (1982) was established for promoting rural and agriculture credit. 11. Based on the recommendations of the Shri Deepak mohanty working group the Reserve Bank issued the guidelines on the Base Rate system on April 9, 2010. Accordingly, the system of base rate came into effect since July 1, 2010. 12. The marketable debt issued by the government or semi-government bodies, which represents a claim on the Government, is known as a Government security or Giltedged security. 13. A kind of finance bills, which are in the nature of promissory notes, issued by the government under discount for a fixed period, not exceeding one year, containing a promise to pay the amount stated there in to the bearer of the instrument, are known as treasury bills. 14. Debt instruments that are issued by corporate houses for raising short-term financial resources from the money market are called Commercial Papers. 15. As per the guidelines of the RBI, Commercial papers are required to be graded by the organization issuing them. 16. Call money market deals in very short period funds called call funds/money. The period ranges from overnight to a fortnight. Whereas Call Money is repayable on the immediate next working day, notice money is repayable within a fortnight.
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17. Call money market is the most sensitive segment of the financial system this is because, any change in demand and supply of short-term funds in the financial system is quickly reflected in call money rates.

SECTION A 1. What is the objective of establishing RBI? 2. What are currency chests? 3. What is CRR? 4. What is SLR? 5. What is Retail Payment system? 6. What is base rate? SECTION B 1. 2. 3. 4. 5. 6. 7. 8. Explain the factors determining the liquidity of banks. What are the limitations of BPLR lending? What do you mean by Base Rate? Explain the features of government securities. Explain the general features of treasury bills. Explain the features of commercial papers. Explain the features of call money. What is the responsibility of RBI as banker to banks?

SECTION - C 1. Briefly explain the functions of RBI. 2. Explain the role of RBI as controller of monetary authority.

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UNIT 3 3 PROFITABILITY RATIOS 3.1 RATIO ANALYSIS 3.1.1 SPREAD RATIOS 3.1.2 BURDEN RATIOS 3.1.3 PROFITABILITY RATIOS 3.2 CAMELS RATING 3.3 PROFIT PLANNING 3.4 BREAK EVEN LEVEL BUSINESS POINTS TO REMEMBER QUESTION BANK

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INTRODUCTION: Profitability analysis is essential for measuring the banks position in the financial market. The profitability of banks can be measured with the help of various parameters. The two important parameters to measure the profitability of banks are balance sheet and profit and loss account. These can be studied as follows: BALANCE SHEET Schedule no. As on 31.3.... (Current year) Rs As on 31.3.... (Previous year) Rs

Capital and Liabilities: Capital Reserves and surplus Deposits Borrowings Other liabilities Total Assets: Cash and balance with RBI Balance with banks and money at call and short notice Investments Advances Fixed assets Other assets Total Contingent liabilities Bills for collection

1 2 3 4 5 xxxx 6 7 8 9 10 11 xxxx 12 Xxxx xxxx

1. Capital (Schedule 1) The capital owned by Central government as on the date of the balance sheet including contribution from government, if any, for participating in World bank projects should be drawn. 2. Reserves and Surplus (Schedule 2) Reserves created in terms of section 17 or any other section of banking regulation act must be separately disclosed. Cash movements in various reserves should be shown as indicated in the schedule.
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3. Deposits (Schedule 3) Deposits include all bank deposits repayable on demand, credit balance in overdraft, cash credit account, deposits, payable at call, overdue deposits, inoperative current deposits, matured time deposits and cash certificates, certificates of deposits, etc. Term deposits are also included in this schedule 4. Borrowings (Schedule 4) Borrowings include finance obtained from the Reserve bank of India, finance obtained from commercial banks, non banking financial companies, finance obtained from IDBI, EXIM, NABARD and other institutions, agencies etc. 5. Other liabilities and provisions (Schedule 5) This includes the net provision for income tax and other taxes like interest tax, surplus in aggregate in provisions for bad debts account, surplus in aggregate in provisions for depreciation insecurities. Contingency funds which are not disclosed as a reserve but are actually in the reserves, proposed, dividend, other liabilities which are not disclosed under any of the major heads such as unclaimed dividends, and provisions and funds kept for specific purposes, unexpired discounts, outstanding charges like rent conveyance etc., 6. Cash & balance with RBI (Schedule 6) This includes cash in hand including foreign currency notes and also of foreign branches in the case of banks having such branches. 7. Balance with banks and money at call at short notice (Schedule 7) This includes balance with banks in current accounts, in other deposit accounts and money at call short notice. 8. Investments (Schedule 8) It includes central and state Govt. Securities and Govt treasury bills. This also includes other approved securities shares debentures and bonds investments in subsidiaries and joint ventures and other residual investments like gold commercial papers and other instruments in the nature of shares. 9. Advances (Schedule 9) This includes bills purchased and discounted cash credit, over drafts and loans repayable on demands. Advances should be broadly classified as advances in India and
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advances outside India. Advances in India will be further classified as on the sectoral basis such as priority sector public sector and banks & others. 10. Fixed Assets (Schedule 10) Premises wholly and partly owned by the banking company for the purpose of business including residential premises should be shown against fixed assets. Depreciation should be provided on motor vehicles and other fixed assets other than premises including furniture and machinery. 11. Other Assets (Schedule 11) This includes inter office adjustment interest accrued, tax paid in advance, TDS, stationery and stamps non banking assets acquired in satisfactions of claims and other items which or reduction in liabilities which have not been adjusted for technical reasons etc., includes claims which have not been met, clearing items, debit items representing additions to assets 12. Contingent liabilities (Schedule 12) These are claims against the banks not acknowledged as debts, liabilities for partly paid investments, liabilities on account of outstanding forward exchange contract, guarantees given on behalf of constituents, acceptance endorsements and other obligations, other items for which the bank is contingently liable such as arrears of cumulative dividends, bills rediscounted under underwriting contracts etc., PROFIT AND LOSS ACCOUNT Schedule No. Year ended on Year ended on 31.3... 31.3.... (Current year) (Previous year) Rs Rs xxxx xxxx

1. Income Interest earned 13 Other income 14 Total 2. Expenditure Interest expended Operating expenses 16 Provisions and contingencies Total 3. Profit/Loss: Net profit/loss for the

15

xxxx xxxx xxxx

xxxx
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year Profit/loss forward

brought

xxxx

Total 4. Appropriations: Transfer to statutory reserve Transfer to other reserve Transfer to govt/proposed dividend Balance carried over to balance sheet Total

xxxx xxxx xxxx xxxx

. Profitability Analysis Admittedly, banking institutions occupy key position in an economy. As a matter of fact, it is difficult to imagine how an economic system could function smoothly without any of their services. Although banks create no new wealth, their lending, investing and related activities facilitate the economic process of production, distribution and consumption. Thus, banks constitute the core of the financial structure of an economy. The growth of Indian banking sector prior to nationalization was not satisfactory keeping in view of the socio-economic requirements of the country. After nationalization, however, the banking sector in India has made commendable progress in extending its geographical spread and functional reach. After nationalization, besides others, commercial banks have been entrusted with the responsibility of discharging certain social responsibilities like financing weaker sections of the society, development of the priority sector and providing banking facilities to such areas and sectors which were hitherto neglected. In short, banks in the post-nationalization period, undertook the responsibilities of catalysts to social change. Despite commendable progress in the post-nationalization era, certain serious problems of the banking sector have emerged reflecting a decline in the productivity and efficiency and erosion of the profitability as a consequence. As a measure of efficiency and productivity, profitability got relegated to the background in view of greater social responsibilities undertaken by the banking sector. However, banks are basically commercial organizations dealing with public funds which come to them solely on the basis of public confidence. Profitability is an index of operational efficiency of banks and their
63

performance among others is gauged on this important parameter. Therefore, the issue of profitability and viability of banks is of considerable importance.

3.1. Ratio Analysis Most often quantitative information in isolation fails to provide a clear-cut view. Therefore, ratio analysis is used to substantiate the trend analysis to identify the causes of changes in profit and profitability over a period of time. Measuring the performance of Indian commercial banks in terms of profitability three sets of ratio has been used. They are:

3.1.1. Spread Ratios Spread plays an all important role in determining the profitability of banks. The surplus of interest earned over interest paid or simply the difference between interest earned and interest paid constitutes the spread. Spread along with non-interest income earned as commission, service charges, etc. forms the revenue pool out of which man power and other expenses are met. The performance vis--vis profitability of banks is usually related to net earnings. Hence, it is the amount of this spread and its components, i.e., interest earned and interest paid, in relation to the total working funds that is significant for the banks to analyze their profitability. Working fund implies total liabilities minus contra items. The three spread ratios are as under:

i.

Interest earned as percentage of working fund

Interest earning represents the return on pure banking business. The major components of the same are: interest and discount earned of advances and income on various investments made by a commercial bank. The ratio of interest as percentage of working funds depicts the rate at which a bank earns income by lending funds. ii. Interest paid as percentage of working fund

Interest paid on deposits and borrowing is one of the major components of the cost structure of the commercial banks. The ratio of interest paid as a percentage of working fund is an indicator of the rate at which bank incurs expenditure by borrowing funds.

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iii.

Spread as percentage of working fund

The ratio of spread as percentage of working fund is considered to be an important ratio which indicates profitability of commercial banks. The ratio is calculated taking the difference between previously computed ratios, namely; interest earned as percentage of working fund and interest paid as percentage of working fund.

3.1.2. Burden Ratios Burden represents non-interest expenditure of commercial banks. Expressed otherwise, it is the combination of man-power expenditure and other expenses of banks minus other incomes. Burden which is met out of spread influences considerably the profit of the bank. Higher the burden of a commercial bank, lower the profitability. Hence, proper management of burden is highly essential if a bank wants to enhance its profit. Burden ratios employed for the present study to determine the profitability of commercial banks are: i. Non-interest expenditure as a percentage of working funds

Non-interest expenditure of commercial banks generally man-power expenditure like salaries, allowances, provident fund, etc. and other current as well as non-current expenditure. ii. Other incomes as percentage of working fund

Other income of the bank, which constitutes earning by way of commission, exchange, brokerage, service charges and other miscellaneous receipts, generally play little role in meeting the non-interest expenditure. But the efforts are made to increase other income so that it can play an important role in reducing burden and simultaneously improving the profitability of commercial banks. iii. Burden as percentage of working fund

The ratio of burden as percentage of working fund is calculated by taking difference between previously calculated two ratios, namely; non-interest expenditure as percentage of working fund and other incomes as percentage of working fund.

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3.1.3. Profitability Ratio Profitability ratio is the common ratio required to judge the performance of commercial banks because absolute profits can be increased by employing more resources but without improving profitability. The analysis of profitability ratio is not only highly important to the management to measure the efficiency of the bank but it is required by different interested parties like shareholders, creditors, etc. to know the return, growth, repayment capacity etc. profitability ratio thus, is quite important. The following profitability ratios have been employed in the present study: i. Profit as percentage of working fund

One of the main analytical tools to determine the bank profitability is the ratio of net profit as percentage of working fund. Working fund implies total liability minus contra items. This ratio indicates the efficiency with which a bank deploys its total resource for maximizing its profits. ii. Profit as percentage of total income Profitability of banks can also be related to the total income of the banks. Total income includes earning on interest and discount, commission, exchange and brokerage and other receipts of the banks.

iii. Profit as percentage of deposits The ratio of profit as percentage of total deposits reveals profit per hundred rupees of total deposits. Total deposits of a bank, generally consists of fixed, saving and current deposits both from public as well as other banks.

3.2.

CAMELS RATING

In 1979, the bank regulatory agencies created the Uniform Financial Institutions Rating System (UFIRS). Under the original UFIRS a bank was assigned ratings based on performance in 6 areas: adequacy of capital, quality of Assets, capability of Management, quality and level of Earnings, adequacy of Liquidity and Sensitivity to market risk. Bank supervisors assigned rating was known primarily by the acronym CAMEL. The r ating of each component is based on, but not limited to, the following evaluation factors:

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i.

Capital Adequacy

Capital adequacy reflects the overall financial condition of the banks and also the ability of the management to meet the need for additional capital. As per latest RBI norms, banks in India should have a CAR of 9%. It is computed by dividing Tier-I and Tier-II capital by the weighted assets. The level and the quality of the capital and the overall financial condition of the institution, the ability of management to address the emerging needs for additional capital and the nature, trend and volume of problem assets along with the adequacy of allowances for loan and lease losses and other valuation reserves. Finally the balance sheet composition and an institutions access to capital markets and other sources of capital including support provided by a parent holding company or emergency lines of credit from affiliated institutions. Capital Adequacy Ratio = Tier I Capital + Tier II Capital .. Risk Weighted Assets

ii.

Asset Quality

The prime motto behind measuring the assets quality is to ascertain the components of Non-Performing Assets as a percentage of the total assets. Thus, assets quality indicates the type of the debtors the bank is having. The adequacy of underwriting standards, soundness of credit administration practices and appropriateness of risk identification practices. The level of distribution, severity and trend of problem, classified, non-accrual, restructured, delinquent and non-performing assets for both on and off balance sheet transactions. Also included is the adequacy of the allowances for loan and lease losses and other asset valuation reserves and the ability of the management to properly administer its assets. iii. Management Efficiency

This parameter is used to evaluate management efficiency as to assign premium to better quality banks and discount poorly managed ones. The level and quality of overseeing and support of all institution activities by the board of directors and management in addition to their ability to plan for and respond to risks that may arise from changing business conditions or the initiation of new activities or product. Management is also rated on the overall performance of the institution and its risk profile. The ratios in this segment involve subjective analysis to measure the efficiency and effectiveness of management. The management of the bank takes crucial decisions depending on its risk perception. It sets vision and goal for the organization and sees that it achieves them.
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iv.

Earning Quality

The level of earnings, including trends and stability and the ability to provide for adequate capital through retained earnings as well as the quality and source of earnings. Also monitored are the level of expenses in relation to operations and the exposure of earnings to market risk such as interest rate, foreign exchange and price risk. This parameter gains importance in the light of the argument that much of a banks income is earned through non-core activities like investment treasury operations, corporate advisory services and so on. In this section assessment is made on the quality of income generated by core activityincome from lending operations.

v.

Liquidity

The adequacy of liquidity sources compared with present and future needs and the ability of the institution to meet liquidity needs without affecting its operations. The availability of assets readily convertible to cash without undue losses and the level of diversification of funding sources. Finally, the capabilities of management to properly identify, measure, monitor and control the institutions liquidity position. Liquidity is very important for any organization dealing with money. Banks have to take proper care in hedging liquidity risk while at the same time ensure that a good percentage of funds are invested in return generating investments so that banks can generate profits while at the same time provide liquidity to the depositor. Demand deposits offer high liquidity to the depositor and so banks have to invest these in high liquid form. It is interesting to note that a high majority of the banks hold more than 100% of the demand deposits in liquid assets. Through mandatory SLR and CRR, RBI ensures that banks maintain ample liquidity.

vi.

Sensitivity to Market Risk

The sensitivity of financial institutions earnings or the economic value of its capital to adverse changes in interest rates, foreign exchange rates, commodity prices or equity prices. Also the ability of management to identify, measure, monitor and control exposure to market risk given the institutions size, complexity and risk profile. This compone nt reflects the degree to which changes in the interest rates can adversely affect an institutions earnings or the market value of equity (MVE). Consideration should be given to: managements ability to measure, manage and control interest rate risk; the institutions size; the nature and complexity of asset/liability management activities; and the level of interest rate risk exposure relative to the adequacy of capital and earnings. One of the
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primary sources of interest rate risk arises from on- and off-balance sheet positions and their sensitivity to changes in interest rates. Important Ratios of CAMEL Model Capital Adequacy Capital adequacy ratio Debt equity ratio Advances to assets Govt.-Securities to total investment Net NPA to total assets Net NPA to net advances Total investment to total assets % change in NPAs Total advances to total deposits Business per employee Profit per employee Return on net worth Operating profits to average working funds Spread to total assets Net profit to average assets Interest income to total income Non-interest income to total income Liquid assets to demand deposits Liquid assets to total deposits Liquid assets to total assets Govt.-Securities to total assets

Assets Quality

Management Efficiency

Earning Quality

Liquidity

Once each of the component ratings have been determined, the composite CAMELS rating is assigned as a summary measure and bank regulators use this rating as the primary indicator of financial condition and performance. Based on the recommendations of the S Padmanabha Committee (appointed by RBI to recommend changes in the on-site supervision of banks), banks are rated on a five point scale (A-E), which is based on the international CAMELS rating model. They are: 1st Rating 2nd Rating 3rd Rating 4th Rating An institution that is basically sound in every respect. An institution that is fundamentally sound, but with modest weaknesses. An institution with financial, operational or compliance weaknesses that give cause for supervisory concern. An institution with serious financial weaknesses that could impact future viability.
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5th Rating

An institution with critical financial weakness that render the probability of failure extremely high in the near term.

3.3. Profit Planning The banks, acting as financial intermediaries, mobilize savings of the society by way of deposits and supplement their resources through borrowings, for providing credit to the needy sectors. They have to pay interest on their deposits and borrowings. They have to pay salaries to their staff and incur other overhead expenses in the course of their business operations. They are also required to make provisions for any potential erosion in their assets. After all this, they may have to pay a reasonable dividend to their shareholders. The banks will, therefore, have to earn profit. Only a profit earning bank inspires confidence in its customers. Profit is excess of income over expenditure during any accounting period, the following five important factors determine the profitability of a bank. i. Working Funds Working funds are the funds deployed by a bank in its business. The amount of working funds so deployed is usually arrived at by subtracting the aggregate amount of contra items from the total liabilities of the balance sheet. The sources of funds for a bank comprise share capital and reserves (owned funds), deposits, borrowings and other liabilities. These are briefly discussed below Share Capital and Reserves: - Share capital is contributed by the shareholders in case of Commercial Banks for the business of the bank and may, therefore, be treated as cost free for the purpose of profitability. Deposits: - The banks pay different rates of interest depending upon the nature and the term of the deposit. The cost of deposits, therefore, depends upon the depositmix of the bank. We have to find out the average cost of these deposits for comparing with the average yield on funds deployed. Borrowings: - these may be by way of borrowings from higher financing agencies, interbank borrowings or refinance from RBI, NABARD, SIDBI, IDBI, NHB etc. The average cost of borrowings and the weighted average cost of each type of borrowing have to be worked out as in the case of deposits. Other liabilities: - the other liabilities include bills payable, drafts payable etc. and represents cost free funds.

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ii.

Cost of funds The average cost of funds for the bank can be worked out as under: i. Average cost of funds (k) = Total interest . X 100 Dividend paid

iii.

Deployment of funds and yield on funds The funds mobilized by a bank through different sources are utilized for1. Compliance with the statutory requirements relating to CRR and SLR 2. Investments in non-SLR avenue 3. Granting loans and advances 4. Deploying in other assets such as land and buildings, furniture and fixtures etc. Cash on hand: - As cash on hand yields no returns, bank should maintain only minimum cash balance required for day to day business. This will also reduce the security risk for the bank. Balance in Current Account (CA): - Amount kept in CA with other bank and if no interest is paid income/yield on this balance will be nil. Investments: -Investments, for the purposes of profitability analysis, include all deposits with the banks including current account balance, and other investments in Government and other securities, shares and debentures etc. The banks have to maintain these investments for the purposes of CRR and/or SLR. The return on these investments comprises interest and dividend actually received. Loans and Advances: - The loans and advances port-folio provides the most profitable avenue for deployment of funds by a bank. Other Assets: - The bank should limit its investments in land & buildings, furniture and fixtures, etc. only to the extent required for their businesses as they do not either earn any return or earn comparatively low returns.

iv.

Other factors The profitability, however, ultimately depends upon the overhead costs, risk cost and the miscellaneous income. These are discussed briefly hereunder: Operating cost: - These are also called management cost/ transaction cost and include all costs other than cost of funds and provisions. Thus, they consist of staff cost, i.e., salaries and other payments such as bonus, gratuity, etc. made to staff (s) and overheads such as expenses on stationery and printing, postages, rents depreciation on assets, etc. Risk cost: - The risk cost is worked out to estimate the likely annual loss on assets as a ratio of Rs. 100/- of average funds deployed. Provisions made towards bad and
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doubtful debts, loss assets should be included under risk cost. In order to ensure a realistic projection of the risk cost banks should systematically estimate bad and doubtful assets each year. Calculation of risk cost can be made on the basis of asset classification and provisioning norms. Non-interest income: - This is the income derived from non-financial assets and services and includes commission and brokerage on remittance facilities, LCs, guarantees, underwriting contracts etc., locker rentals and other rentals and other service charges. However, items of non-recurring nature such as profit from sale of non-banking assets, when significant should not be included. Financial margin: - Just as a trading or manufacturing organization arrives at its gross profit to assess its trading or manufacturing activities, banks also ascertain their gross profit. This is also called spread and is computed as a difference between weighted average yield on assets and weighted average cost of funds. Burden: - The total non-interest expenses representing the transactions costs will generally be more than miscellaneous income. The difference between the two is called burden, as while making a cost plus pricing of loans this difference has to be loaded onto the rate of interest. The concept of burden also illustrates the importance of non-interest or service income of the bank. A high level of noninterest income can not only recover the entire operating cost, it can enable a bank to pay high level of compensation to its employees, as in the case of foreign banks.

3.4. Tools of financial analysis There are some widely popular tools of financial analysis. Some of these are discussed hereunder: 1. Trend Analysis: - This is done through comparison of two or more successive balance sheets and P&L A/Cs and studying the changes in the various components of assets and liabilities and income and expenditure. 2. Break Even Level Business (BEL): - This is the level of business (in terms of working funds) at which the total income of the bank is just adequate to meet all its costs. It is calculated as follows:

BEL

= (Transaction Costs + Risk Cost) - Non-interest Income . X 100 Net Margin In case the present level of working fund is more than BEL, the bank would be in profit and the actual profit can be arrived as follows: Profit = (Actual working funds BEL working funds) X Net margin
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3. Factors separation analysis or ratio analysis In factor separation analysis all the items or a banks income statement, non-interest income, trading income, other interest income, interest expenditure, staff cost, operating overheads, provisions and profit are divided by average working fund s or average total assets. If we take the ratios of two successive years, the difference between ratios of two years under each item represents the contribution of that item towards profitability (profitability being denoted by profit/total assets). This helps us in identifying what has contributed to or detracted from Narasimham Committee on Profitability of Public Sector Banks. Apart from this the Narasimham Committee (1991) clearly explained that the deteriorating profitability of Public Sector Banks in India was the result of two sets of factors, that is: Declining interest income for banks and, Increasing cost of operations The declining interest income was the result of the high proportion of the total deposits being held up in CRR and SLR and earning relatively low rate of interest. Further a high proportion of bank deposits had to be allocated to priority sector under social banking and the rate of interest earned was quite low. Above all, a large proportion of these loans became doubtful debts (NPAs). The break even analysis and the factor separation analysis give fair idea of the past performance of the bank. In the light thereof the bank has to diagnose the past, look into the future, anticipate the course of events and prepare strategies for improving the productivity and operational efficiency of the bank. As part of the profit planning, the bank should devise strategies for reducing of costs, maximization of revenues and optimal utilization of all its resources including the human resources. Further, banks should go for new sources of funds for example Certificate of Deposit (CDs), could bring in additional fund for the bank which in turn could lend the amount to the corporate sector at profitable rates of interest and diversification of banking activities.

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POINTS TO REMEMBER The difference between interest earned and interest paid constitutes the spread. Interest earning represents the return on pure banking business. Spread along with non-interest income earned as commission, service charges, etc. forms the revenue pool out of which man power and other expenses are met. Burden represents non-interest expenditure of commercial banks. Higher the burden of a commercial bank, lower the profitability. Working fund implies total liability minus contra items. The prime motto behind measuring the assets quality is to ascertain the components of Non-Performing Assets as a percentage of the total assets. Profitability of banks can also be related to the total income of the banks. Capital adequacy reflects the overall financial condition of the banks. As per latest RBI norms, banks in India should have a CAR of 9%. CAR is computed by dividing Tier-I and Tier-II capital by the risk weighted assets. Through SLR and CRR, RBI ensures that banks maintain ample liquidity. Working funds are the funds deployed by a bank in its business. Operating cost are also called management cost/ transaction cost. Non-interest income is the income derived from non-financial assets and services. Trend Analysis is done through comparison of two or more successive balance sheets and P&L A/Cs. Break Even Level Business (BEL) is the level of business at which the total income of the bank is just adequate to meet all its costs. The risk cost is worked out to estimate the likely annual loss on assets.

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SECTION A 1. 2. 3. 4. 5. 6. 7. 8. 9. What is spread? What is burden? Expand CAMELS? What is working fund? What are the tools of financial analysis? What are the types of ratios in terms of profitability? What is cost of funds? What is Break Even level? What is trend analysis?

SECTION B. 1. What are the factors affecting profit? 2. What are the tools of financial analysis? 3. Write brief notes on spread ratio? 4. Write brief notes on burden ratio? 5. Write brief notes on profitability ratio? SECTION C 1. Write notes on CAMELS rating? 2. What is profit planning? 3. What is ratio analysis and write in detail its types?

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UNIT 4 4.1 4.2 4.2.1 4.3 4.3.1 4.3.2 4.3.3 4.3.4 4.4 4.4.1 4.4.2 4.4.3 4.4.4 4.4.5 PRINCIPLES OF SOUND LENDING PROJECT APPRAISAL PURPOSE OF TERM LOAN APPRAISAL NON PERFORMINF ASSETS CLASSIFICATION OF ASSETS IMPORTANCE OF MANAGEMENT OF NON PERFORMING ASSETS REASONS FOR AN ASSET TURNING NON PERFORMING ASSET STRATEGIES OF NPA MANAGEMENT SECURITIZATION CONCEPTS OF SECURITIZATION PARTIES INVOLVED IN SECURITIZATION OTHER PARTIES INVOLVED IN SECURITIZATION TRANSACTION STEPS IN SECURITIZATION ADVANTAGES IN SECURITIZATION

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The business of lending carries certain inherent risks. A large percentage of banks funds consist of deposits on different terms, repayable according to the contractual obligations with the depositors. Largely depending on the borrowed funds a banker cannot afford to take undue risk in lending. While lending his funds, a banker, therefore, follows a very cautions policy and conducts his business on the basis of certain principles of sound lending in order to minimize the risks. 4.1 Principles of sound lending (Credit) There are certain cardinal principles of good lending that have been followed by commercial banks since long. These are the principles of safety, liquidity, profitability, spread of risks-diversification, purpose and security. i) Safety: Safety first is the most important principle of good lending. As the bank lends funds entrusted to it by the depositor the first and foremost principle of lending is to ensure the safety of funds lent. By safety is meant that the borrower is in a position to repay the loan along with interest, according, to the loan contract, which depends upon the borrowers capacity and willingness to pay. While the capacity of the borrower depends upon his tangible assets/financial strength and success of his business/earning of profit from business to repay the loan, the willingness to repay depends upon the honesty and character of borrower. The banker should, therefore, take utmost care in ensuring that enterprise or business for which a loan is of carrying sought is a sound one and the borrower is capable of carrying it out successfully and the borrower is a person of integrity, good character and reputation. In addition to the above, the banker should consider the security of tangible assets owned by the borrower to ensure the safety of his funds. The banker should ensure that the money advanced by him goes to the right type of the borrower and is utilizes in such a way that it will not only be safe at the time after of lending but will remain so throughout, and ultimately serving a useful purpose in the trade or industry. Where it is employed, is repaid with interest. ii) Liquidity: It is not enough that the money will ultimately come back, it is also necessary that it must come back more or less on demand or within settled schedule or repayment programme under which loan was granted. Banks are mainly intermediaries for short-term funds and, therefore, generally they lend funds for

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iii)

short periods and mainly for working capital purpose. The borrower must be in a position to repay within a reasonable time after a demand for repayment is made. Profitability: Equally important is the principle of profitability in bank advances . Firstly, they have to pay interest on the deposits received by them. They have to incur expenses on establishments, rent, stationery, etc., They have to make provision for depreciation of their fixed assets and also for any possible bad or doubtful debts. After meeting all these items of expenditure which enter the running cost of banks, a reasonable profit is needed to carry the reserves and payment of divided to the shareholders. Banks, therefore, grant advances for those transactions which are on the whole secured and profitable for the bank. Spread of Risks-Diversification: Another important principle of good lending is the diversification of advances. An element of risks is always present in every advance, however, secure it might appear to be. To safeguard the banks interests, a banker follows the principle of spread of risks based upon the maximum Do not keep all the eggs in one basket. It means that a banker should not grant advanced to a few big units only but to a larger number of industries and areas and over different type of securities.

iv)

v)

Purpose: While granting loans, a banker must ensure that the purpose of loan should be productive so that the, money not only remain safe but also provide a definite source of repayment. A banker must closely scrutinize the purpose for which the money is required, and ensure that the money borrowed for a particular purpose is applied by the borrower accordingly.

vi)

Security: While granting advances banks consider the availability of security as one of the important guiding principles. Security is considered as insurance or a cushion to fall back upon in case off an emergency. Since bank deal in the public money, it is very important to pay proper attention to the security offered against the loan/advances. A good security must have qualities (MAST characteristics) such as marketability; ascertain ability, stability and transferability.

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4.2 PROJECT APPRAISAL: In general, term loan from banks and financial institutions is the main source of funds for financing of fixed assets. Relatively speaking, for banks, risks in term loan is high since repayment is expected to take place over a period of 5-7 years during which there could be many uncertainties in respect of performance of the firm, value of money, erosion in the value of securities, integrity of the borrower, etc. Hence, it calls for a detailed appraisal of term loan not only to keep the entrepreneur happy but also to ensure a professional approach in financial analysis and decision making and also to observe due to diligence of lending norms, comply with policy guidelines and global best practices. 4.2.1 PURPOSE OF TERM LOAN APPRAISAL; The main purpose of term loan appraisal is to confirm whether funds are safe in the hands of a potential borrower and the project would generate sufficient cash surplus from the operations to service the debt and repay the principal amount. For this purpose, a scrutiny of the projected statements by using analytical tools is a must. Further, judgment has to be exercised by the credit officer by taking a view on assumptions made in preparing the projected statements and overall integrity and reputation of the borrower based on available information. Thus, appraisal of term loan involves two major criterions to decide on the borrowers request: Borrowers Appraisal and Project Appraisal. a) Borrowers Appraisal: Borrowers appraisal refers to the assessment of the person behind the project, who may be a proprietor, a key promoter/director, etc. For appraisal of the borrower, several aspects need to be looked into which may include his educational and profession and professionals in key management areas, leadership qualities, credit history of the persons concerned, compliance of KYC norms for a new borrower, age and physical health of the borrower, etc. For appraisal of the borrower, attention should be paid to 5 Cs, viz., character (intention to repay, reputation), capacity (ability to manage the enterprise), capital (financial stake), collateral, and conditions (possibility to comply with the laid down terms and conditions). To gather the required information for appraisal of the borrower, it is necessary to refer to several sources of information such as loan application form; past dealings with the bank by the borrower; credit report from other banks; report from the supplier/customer of the borrower if it is an existing firm, report from the guarantor, newspaper-cuttings or personal enquiry in the market, and study of annual report of a company. Even the credit information Bureau of India (CIBIL) coin provide sufficient information by giving rating to the client.
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b) Project/Credit Appraisal: In this regard, it is necessary to study various aspects of term lending which include: i) Cost of Project and Sources of funds: The capacity of the firm to mobilize resources to meet project cost depends upon the current position of stock market/debt market, regulatory framework, promoters contribution in the form of net worth (in case of exiting firms) being sufficient to meet margin money for working capital, project related expenses such as preliminary and pre-operative, R&D, etc., for which bank finance is not available for future expansion. Hence, banks should ensure that the lending norm of debt-equity ratio is complied with, which is indicated in the bank scheme/loan policy. This ratio is decided by considering several factors including the position of market, project cost, tax, laws, etc. Regarding subsidies from the Government, the borrower is expected to furnish an undertaking to the bank to bring in the equivalent of funds and retain the same until the receipt of subsides. ii) Scrutiny of Projected Production, Profitability Statements and Cash Flow Statements: The projected production and profitability statements and cash flow statements are very important documents for the term loan appraisal. The projected production and profitability statement helps in assessing (i) earning capacity of the firm, (ii) capacity of the firm to amortize and service the borrowed cost, (iii) ability to service the share capital, and (iv) surplus available for future expansion. This statement is useful to calculate break-even analysis, internal rate of return, inter-firm comparison, etc. The projected cash flow statement is prepared based on the projected production and profitability statement and projected balance sheet. The projected cash flow statement helps in ascertaining the timing and adequacy of cash surplus, available for servicing of loan and payment of term loan installments. This also helps in deciding the moratorium period or repayment holiday, maturity of loan and repayment schedule.
iii) Compliance of Lending Norms:

The decision to sanction term loan depends upon compliance of lending norms which include Debt: Equity (D: E) Ratio, Debt Service Coverage Ratio (DSCR), Internal Rate of Return (IRR), Sensitivity Analysis and Breakeven (BE) Analysis. DSCR should be calculated for each year of the loan period. Regarding IRR, it
80

should be higher than the weighted average cost of total funds for the firm. Normally, each bank sets a desired IRR for the purpose of credit appraisal which is normally 2 to 3 percent higher than cost of funds. Sensitivity analysis is useful to assess the financial soundness even under the adverse situations. Lastly, each firm is expected to breakeven early (preferably within 6-12 months from the date of commencement of commercial operations by SMEs and a little longer in respect of non-SMEs) and also at lower plant capacity (preferably at 50-60 percent of installed plant capacity). This would ensure the margin of safety in terms of contribution per unit (selling price per unit less variable cost per unit).
iv) Repayment Schedule:

Usually, the maturity of term loan ranges from 3-7 years. But in respect of capital intensive project, it is still longer. The repayment period is fixed taking into the Projected Cash Flow Statement, DSCR and IRR. Moratorium period or initial repayment holiday (from the date of disbursement till the due date of commencement of commercial production) may be granted based on cash losses (cash payments less receipts) that the firm may incur in the beginning. But interest on term loan should be fixed on quarterly basis from the date of disbursement of term loan. The payment of interest and loan installment starts after the repayment holiday. The rate of interest on term loan should be as per the loan policy of the bank.
v) Deferred Payment Guarantee:

This is essentially a non-fund based facility granted to a borrower for availing a deferred credit from suppliers for purchase of machinery, capital goods, etc. As agreed upon, the bank is liable to make the payment of installments to the suppliers or retire bills upon the borrowers default. To grant Deferred Payment Guarantee (DPG) by bank, appraisal should be done on the same line of term loan.
vi) Securities:

Term loan should be secured against hypothecation/mortgage of fixed assets. All charges should be registered with the Registrar of Assurances and Registrar of Companies.
vii) Pre-Sanction Inspection:

To ensure the end use of funds, pre-sanction inspection is a must. In the case of existing unit, inspection should be done at the site. The inspection report should cover the position of licenses/registration formalities, arrangements for
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importing of machines, details of foreign collaboration, particulars of land, position of power, time schedule for implementation of project, likely date for carrying out trial run, progress made in the promoters contribution, list of existing fixed assets, etc. In this regard, banks have developed pre-sanction inspection report format.
viii) Documentation and Disbursement:

Prior to documentation, it should be ensured that all terms and conditions of term loan are fulfilled. In respect of high value advances, documents prepared at the branch need to be approved by the lawyer/law officer of the bank. No disbursement should be done unless all documents are executed.
ix) Schedule of Implementation:

The project report should contain the time schedule for implementation of the project which shall be supported by the PERT chart, wherever feasible. This progress in implementation should be closely monitored by obtaining a periodical progress report and conducting inspection at the site/factory. Banks have developed a prescribed format for progress report and site/factory inspection report which should be filled in periodically and kept on record. Reasons for delay in implantation, if any, should be ascertained and implications of the same on project cost should be ascertained. x) Post-Implementation follow up: After the project has been implemented and commercial operations begin, follow-up of actual performance of the firm is called for. Actual performance in production, sales, profits, etc., should be compared with the budgeted performance on periodical basis. Banks have developed formats for follow-up, such as Monthly Select Operations Data (MSOD), Quarterly Information System (QIS), etc. In addition, factory inspection should be carried out at least once a year and a copy of the visit report should be kept on record. xi) Cost Over-run: Cost over-run may occur due to delay in implementing the project, leading to increase in the cost of assets purchased, adverse exchange fluctuation, hike in custom, duties, etc. Normally, provision made for contingencies would meet the marginal cost over-run. The borrower is expected to meet such cost over-run from his own resources. This should be stipulated in the specified terms and conditions.

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xii) Terms and condition: Besides, standard terms and conditions as applicable to all borrowers, additional terms and conditions may be considered for a specific borrower. For instance, wherever risk is perceived to be high, personal guarantee of the borrower may be sought for. xiii) Due Diligence in Credit Appraisal: In terms of bank guidelines, it is necessary to observe due diligence for offering term loan. It is difficult to prepare a long list of items of due diligence. But major items of due diligence in credit may include: Fulfill the KYC norms for opening a savings/current account by a potential borrower obtain photograph, IT PAN, sales tax/excise registration number, shop and establishment registration number, etc., of the persons authorized to operate the account. Give a loan application form only if found eligible under the bank scheme. Receive the loan application form if filled in properly and submitted along with: project proposal, financial statements both audited (for the last three years) and projected balance sheet, profit and loss account and cash flow statement, copies of the relevant certificates, bio-data of the promoter, etc. The project proposal should contain the required details which should be verified carefully. Issue a receipt of the loan application form and record in the Loan Application Received Register in case of proposals from small borrowers. As a part of credit appraisal, verify the documents such as partnership deed, certificate of incorporation cum articles of association, resolution of the board to raise borrowing, trust deed, certificate of registration, and verify the registered office/business office address. Obtain market report of the borrower, credit report from the existing bankers, and reference letters.

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 Ascertain the details of existing borrowing arrangements with the present bank and other banks, if any. Assess the financial status of associated companies, if any, and call for their latest audited financial statements. Scrutinize the details of the guarantors which include their relationship with the borrower, net worth, business activities, if any, securities to be offered, etc. Conduct pre-sanction inspection to verify information as furnished in the loan application form and assess the antecedents of the promoters/guarantors. Verify the details of the securities to be offered; proof of the residence, lease deed, sale deed, rent agreement, etc., and obtain a search report. Interview the applicant and record the conversation in brief. Prepare a credit appraisal/process note. Sanction credit facilities keeping in mind the lending powers and sent a draft letter of sanction to be borrower stating the required details including the terms and conditions and obtain his/her written consent. If decided not to sanction, state reasons thereof. Observe the time limit set for loan sanction. Execute documents as per guidelines of the bank. Obtain documents properly stamped and vetted. Create legal charge over the assets financed including collaterals. Disburse the loan amount as per bank guidelines. Promoters contribution should be deposited first before disbursement of the amount. The amount should be disbursed as per the progress made in construction work, procurement of capital assets, etc. Conduct post-disbursement inspection of the factory/business within a month from the date of disbursement to ensure the end use of borrowed funds.

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xiv) Preparation of Appraisal Note: The note should conclude with the bank decision which could be yes (with terms and conditions) or no (with convincing reasons). If decided to sanction the term loan, terms and conditions have to be indicated. There is no standard format for preparing the appraisal/process note. But it should be ensured that the note is carefully prepared covering all vital aspects of the borrower and his project. CONCLUSION: Banks have a lot of potential to provide term loan in the present context of higher economic growth. Banks have to adopt a professional approach in credit decisions; since risk associated with term lending is perceived to be high.

4.3. Non-performing assets One of the important recommendations of narsimhan committee was that balance sheets of the banks should be transparent and comply with international accounting standards. The committee recommended, the banks should adopt uniform accounting practices in regard to income recognition and bad debt provisioning. Income recognition of non-performing assets should be on the accrual basis but on record on recovery. The committee also recommended that provisioning should depend upon a proper classification of assets, which in turn should be based on objective criteria. Non-performing assets (NPA) means an asset or account of borrower, which has been classified by a bank or financial institution as standard asset, sub-standard asset, doubtful or loss asset in accordance with the direction or guidelines issued by RBI(Reserve Bank of India). With a view to moving towards international best practices and to ensure greater transparency, it has been decided to adopt the 90 days overdue norm for identification of NPA's from the year ending March 31, 2004. A non-performing asset (NPA) shall be a loan or an advance where:

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 Interest and/or instalment of principal remain overdue for a period of more than 90 days in respect of a term loan. The account remains out of order for a period of more than 90 days in respect of an overdraft/cash credit(OD/CC). The bill remains overdue for a period of more than 90 days in the case of bills purchased and discounted. Interest and/or instalment of principal remains overdue for harvest seasons but for a period not exceeding two half years in the case of an advance granted for agricultural purpose. Any amount to be received remains overdue for a period of more than 90 days in respect of other accounts. 4.3.1 Classification of assets a) Standard assets: Standard assets are those assets which do not pose any problems and which do not carry more than normal risk attached to the business. These are not non-performing assets. Banks have been asked to make provision @0.25% on their standard advances also from the year ending March 31st 2000.

CLASSIFICATION OF LOAN ACCOUNTS

LOANACCOUNTS

PERFORMINGASSET

NON- PERFORMING ASSETS

LOAN A/Cs WHICH ARE NOT NPA

NON-PERFORMING ASSETS

OVERDUE UPTO 3 YEARS

OVERDUE OVER 3 YEARS

LOAN CONSIDERED NOT RECOBERABLE

STANDARD ASSETS

SUB-STANDARD ASSETS

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DOUBTFUL ASSETS

LOSS ASSETS

b) Sub-standard assets: Sub-standard assets are those which have been classified as NPA for a period not exceeding two years. The security available to the bank is inadequate and there is distinct possibility that the bank will suffer some loss, if deficiencies are not corrected. Provisions have to be made at the rate of ten percent of the total outstanding amount of sub-standard assets. c) Doubtful assets: Doubtful assets are those which have remained as NPA for a period exceeding two years. This period of two years is being reduced to 18 months by March 31, 2001. These assets are so weak, their collection or liquidation in full is considered highly improbable. In order to arrive at the amount of provision to be made against doubtful assets, provision has to be made even against the secured portion on the following basis:

PERIOD FOR WHICH THE ADVANCE HAS PERCENTAGE OF PROVISION ON THE BEEN CONSIDERED AS DOBTFUL SECURED PORTION TO BE PROVIDED UPTO ONE YEAR ONE TO THREE YEARS MORE THAN THREE YEARS 20 30 50

d) Loss assets Loss assets are those were the loss has been identified by the banker, internal or external auditors or RBI (Reserve Bank of India) inspectors but the amount not been written off wholly or partly. These assets are uncollectible and, therefore, they must be written off even though there may be a remote possibility of recovery of some amount. Provision of 100% of the outstanding balance should be made. Provisioning requirement

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ASSET CATEGORY STANDARD ASSETS Secured Unsecured DOUBTFUL ASSETS Doubtful I

PROVISION REQUIRED Provision of 10% outstanding Provision of 20% outstanding Provision of 20% of realizable value of security plus 100% of shortfall of security Provision of 40% of realizable value of security plus 100% of shortfall of security Provision of 100% Provision of 100%

Doubtful II

Doubtful III LOSS ASSETS

4.3.2 Importance of management of NPA With the introduction of norms for Income Recognition and Asset Classification (IRAC) in the banking sector in India, management of Non-Performing Assets (NPAs) has emerged as one of the major challenges facing Bankss thereby making them more cautious in extending loans. Once an asset ceases to generate any income for a bank, whether in the form of interest or principal repayment, it is termed as Non-Performing asset. As per the prudential norms suggested by the RBI, a Bank cannot book interest on an NPA on accrual basis. An NPA account not only reduces profitability of banks due to provisioning in the profit and loss account, but their carrying cost results in excess and avoidable management attention. Apart from this, high level of NPAs also puts a strain on the banks net worth, because banks are under pressure to maintain a desired level of capital adequacy and in the absence of comfortable profit level, they eventually look towards their internal financial strength thereby slowly eroding the net worth. High NPAs will also raise corporate governance issue where every stakeholder is keen to know the reasons for high level of NPAs.

The most important objectives of NPA management strategy are: Improving the quality of loan asset with a view of transferring them from nonperforming to performing status. As a result of such improvement in quality, income of such assets can be recognised.
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 Upgrading the status of loan asset with a view to reducing the quantum of provisions to be made on such loan assets. Cleansing the balance sheet of loss assets and clean portion of doubtful assets thereby achieving an improvement in capital adequacy ratio. 4.3.3 Reasons for an asset turning NPA Various studies have been conducted to analyse the reasons for NPA whatever may be, complete elimination of NPA is impossible. The reasons were generally classified into two: Overhand component-due to environmental reasons, business cycle etc. Incremental component- due to internal bank management, credit policy, terms of credit etc. 4.3.4 Strategies of NPA management The primary objective of the banking industry is to reduce the NPAs to manageable level. The following recommendations are suggested by RBI for preventing slippage of NPAs from sub-standard to doubtful/loss category. Broadly speaking the recovery measures can be classified as non-legal and legal measures which are as follows:

a) Non-Legal Measure i) Reminder system This is the cheapest mode of recovery by sending reminders to the borrowers before the loan instalment falls due. With the migration of branches to the core banking solution (CBS) and the internal facility being available, reminders can be sent through e-mail. ii) Visit to borrowers business premises/residence This a more dependable measure or recovery. Visits need to be properly planned. Involvement of staffs at all levels is to be ensured. Costs involved in the recovery need to be kept to the minimum. Recovery camp To take the maximum advantage, recovery camps should be organised in a planned way, for instance, in respect of agricultural advances during the harvest season. It is also essential to take the help of outsiders, particularly, revenue officers in the state government and the local panchayat officials. During the camp, those who are

iii)

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very regular in loan repayment should be honoured. This would send out a positive message across the people. iv) Rehabilitation of sick companies By rehabilitating a sick unit successfully, a bank can recover the dues. Debt restructuring Its success depends upon both banks and borrowers. Banks need to create a conducive environment for loan recovery through collective efforts. Credit counselling to borrower by banker is a must to make debt restructuring more result oriented. It is noteworthy that RBI has issued guidelines regarding restructuring of loans, as a onetime measure and for a limited period of time in view of extraordinary external factors, for preserving the economic and productive value assets. Loan compromise Compromise settlement should be considered as a last resort or recovery. Many banks have set up a Settlement Advisory Committee (SAC). Efforts should be made not to encourage good borrowers to seek compromise. It should be case specific based on the ground realities. Rephasement /reschedulement Banks need to be empathetic in case of small advances and more particularly in respect of sincere and hardworking borrowers. If such borrowers fail to pay loan instalments due to natural calamities or for some other convincing reasons, unpaid loan instalments may be rephased or rescheduled.

v)

vi)

vii)

viii)

Write-off If it is going to be unremunerated either to file suit and/or continuing the account in the banks books, it is advisable to go for waiver of legal action and/or write off dues. The write-off exercise is internal and the branch staff should continue the recovery process even after write-off is carried out. Recovery agents Recovery agents shall be appointed to recover the amounts lying in various NPA accounts. While appointing the recovery agents, their professional expertise, experience and qualification should be factored in.

ix)

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b) Legal measures i) Compromise settlement scheme The broad framework for compromise or negotiated settlement of NPAs advised by RBI in July 1995 continues to be in place. Banks are free to design and implement their own policies for recovery and write-off incorporating compromise and negotiated settlements with the approval of their boards, particularly for old and unresolved cases falling under the NPA category. One-time settlement(OTS) scheme One-time settlement (OTS) scheme was launched for the first time in May 1999 and specific guidelines were issued to Public Sector Banks (PSBs) for onetime nondiscriminatory settlement of NPAs of small sector. It was again introduced in July 2000 and was further extended up to July 31, 2004. The guidelines are applicable to cases in which the banks have initiated action under the SARFAESI Act, 2002 and also cases pending before courts/DRTs/BIFR, subject to consent decree being obtained from the courts/DRTs/BIFR. Lok Adalats One of the initiatives taken by DRTs for the recovery of NPAs is that DRTs have started holding Lok Adalats. By now it has become a usual feature of the legal system for effecting mediation and conciliation between the parties and to reduce burden on the courts/DRTs especially for small loans. As far as recovery of smaller loans is concerned, Lok Adalats have proved a very good agency for quick justice and settlement of dues. With the enactment of Legal Service Authority Act, 1987, Lok Adalats were conferred a judicial status and have since emerged as a convenient method for settlement of disputes between banks and small borrowers. The RBI has issued guidelines to commercial banks and financial institutions to enable them to make increasing use of Lok Adalats convened by various DRTs/debt recovery appellate tribunals (DRATs)for resolving cases involving Rs.10 Lakhs and above to reduce the stock of NPAs. The government has, in August 2004, revised the monetary ceiling of cases to be referred to Lok Adalats organised by civil courts. As a result the scope of the Lok Adalats is now expanded to cover both suit filed and non-suit filed cases for recovery of dues in accounts falling in the doubtful and loss categories with outstanding balance upto Rs.20 Lakhs, by way of compromise settlement.

ii)

iii)

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iv)

Debt Recovery Tribunal The recovery of debts due to banks and Financial Institutions Act, 1993 was enacted on 27th August 1993 to provide for the establishment of Debt Recovery Tribunals (DRTs) for expeditious adjudication and recovery of debts due to Banks and Financial Institutions and the matters connected therewith and incidental thereto. At present, there are 29 DRTs set up at major centres in the country with 5 Debt Recovery Appellate Tribunals (DRATs) located in five centres namely Mumbai, Allahabad, Delhi, Calcutta and Chennai. The Act was amended in 2000. Securitization and Reconstruction of Financial Assetsand Enforcement of Security Interest (SARFAESI) Act. 2002 In order to implement the recommendations of Narasimhan Committee on Banking Sector Reforms (April 1998), the Government of India has constituted an Expert Committee under the Chairmanship of Shri T.R. Andhyarujina. The committee in its report submitted in February 2000, inter alia, proposed a draft Securitization Bill and changes in legal provisions relating to enforcement of security interest without the intervention of the court. While the Debt Recovery Tribunals will be the usual mechanism for recovery of the debts for unsecured loans, for secured loans, the proposed draft bill confers the power on the banks and financial institutions to take over the securities from the borrowers and sell the same without the intervention of the court. The Security Interest (Enforcement) Rules, 2002 has also been notified by Government to enable Secured Creditors to authorise their officials to enforce the securities and recover the dues from the borrowers. The Public Sector Banks and Financial Institutions (FIs) have been advised to take action under the Act and report compliance to RBI.

v)

vi)

Asset Reconstruction Companies An Asset Reconstruction Company (ARC) is a company specialised in recovery and liquidation of assets. The NPAs can be assigned to ARCs by banks at a discounted price. ARC has the objective of floating bonds and making recovery from the borrowers directly. The need for the setting up of an Asset Reconstruction Company for acquiring distressed Assets from the Banks and Financial Institutions with a view to develop market for such Assets was being felt, since long. The Narasimhan Committee on Financial System (1991) has recommended the setting up of Asset Re-construction Fund (ARF), which will take over the bad debts of banks from their Balance Sheets to enable them to start on a clear state. Subsequently, the Narasimhan Committee on Banking Sector Reforms (1998)
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recommended transfer of sticky assets of banks to an ARC. Further, Verma committee on Restructuring Weak Public Sector Banks (1999) has also strongly recommended the setting up of ARCs. The ARCs are envisaged to enable the banks and financial institutions to sell off/transfer the NPAs. The sale proceeds of the assets are to be used for the payment to the Secured Creditors for the assets taken over from them. The ARCs or Securitization Companies can acquire the distressed financial assets of any Banks or Financial Institutions. On such acquisition, they shall be deemed to be lender and the rights of transferor banks and Financial Institutions will vest with them. As a result of enactment of SARFAESI Act, the first Asset Reconstruction Company called Asset Reconstruction Company of Indian Limited (ARCIL) was promoted by the ICICI Bank, State Bank of India and IDBI with the authorized capital of Rs.2000 crores and initial paid up capital of Rs.1400 crores. So far, the RBI has granted certificate of registration to three ARCs including ARCIL. ASREC (India) Limited has been started recently. In order that ARCs have a sound capital base and a stake in the management of NPAs acquired, the requirement of owned funds for commencement of business has been stipulated as not less than 15 percent of the assets acquired or Rs.100 crore, whichever is less. vii) Corporate Debt Restructuring (CDR) One of the methods suggested for the reduction of non-performing assets is Corporate Debt Restructuring (CDR). The process is primarily rescheduling the debt portfolio of the borrowers among its creditors to help the borrowers in the revival of projects and continue operations through reductions existing debt burden and establishment of new credit lines with implied assumption that the lender would prefer reduction in risk to optimisation of returns. The objective of the CDR is to ensure a timely and transparent mechanism for restructuring of the corporate debts of viable corporate entities affected by internal and external factors, outside the purview of BIFR, DTR or other legal proceedings, for the benefit of all concerned. It is applicable to standard and sub-standard accounts with potential cases of NPAs getting a priority. The Scheme of Corporate Debt Restructuring (CDR) was developed in India based on international experience and detailed guidelines on the same were issued to Banks and Financial Institutions in 2002 for implementation. The scheme was further fine-tuned in February 2003 based on the recommendations made by a Working Group under Shri Vepa Kamesam. It has three tier structures namely CDR standing Forum, CDR Empowered Group and CDR Cell.
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Entry into CDR protects the company from law suits filed by individual lenders. An induction into CDR would help company reduce the interest rate on its loans and stretched the loan repayment period. But the CDR guidelines say that only companies in trouble because of reasons beyond the managements control could be admitted. In BIFR case without their express approval are not eligible for restructuring. No accounts should be taken up for restructuring by the banks enters the financial viability is established and there is a reasonable certainty of repayment from the borrower. The viability should be determined by the banks based on the acceptable viability benchmarks determined by there, which may be applied on a case-by-case basis.

viii)

Circulation of Information on Defaulters Periodical circulation of details of wilful defaulters of banks and financial institutions by RBI is also suggested as a measure for reduction of NPAs. Now, RBI publishes a list of borrowers (with outstanding aggregate Rs.1 crore and above) against whom suits have been filed by banks and financial institutions as on 31st March every year. Credit Information Bureau Banks and lending institutions have a traditional resistance, because of the confidential nature of banker-customer relationship, to share credit information on the client, not only with each other, but also across sectors. There has been a widely felt need to establish a Credit Information Bureau (CIB) designed to obtain and share data on borrowers in a systematic manner for sound credit decisions, thereby helping to facilitate avoidance of adverse selection. This would also facilitate reduction in NPAs. The banking commission (1972) under the chairmanship of Shri R.G. Saraiya, recommended setting up of a Credit Information Bureau as a statutory body, which would furnish adequate and reliable credit information to banks and other financial institutions.

ix)

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4.4 SECURITIZATION With the introduction of financial sector reforms, there have been innovations in development of financial instruments. Securitization of assets is a good source for recycling of funds in addition to the existing avenues. Securitization has been introduced in some areas like hire-purchase receivables, property rental receivables, lease receivables and fees receivables; also companies can securitize their receivables and future cash flows. 4.4.1 Concepts of Securitization: In simple words, securitization is the repackaging of future cash flows into tradable securities. Cash flows are transferred to a special purpose vehicle (SPV), which issues securities to finance the purchase of the price payable. This leads to creation of financial instruments that represent ownership interest in or are collateralised by a homogenous or sometimes, even diversified pool of assets. Thus, it is a process by which a pool of credit assets of a lending institution is sold to a trust, which in turn issues securities against the backing of such assets and sells the same to prospective investors. The lending institution undertakes to service the debt and to pass on the recovery of principal and interest, to be distributed pro-rata among the investors in partial or full liquidation of the securities. The investment can be with or without recourse. Where the investment is with recourse, the investor does not suffer loss as it is to be borne by the trust or the lending institution as per the terms of contract. On the other hand, where it is without resource, the investor takes the risk and suffers loss because of non-recovery of the loans. 4.4.2 PARTIES INVOLVED IN SECURITIZATION: Securitization basically involves three parties: Originator:(a bank, an NBFC or a housing finance company)-The unit on whose books the assets to be securitized exist. It is the prime mover of the deal. It sells the assets on its books and receives the funds generated from such a sale. Special purpose vehicle (SPV):It is the unit that buys the assets from the originator. It has independent trustees/directors. As the main objective of securitization is to remove the assets from the balance sheet of the originator, the SPV plays a vital role in as much as it holds the assets in its books and makes the upfront payment to the originator. Investors:The investors may be individuals or institutional investors like banks, financial institutions (FIs), mutual funds, provident funds, pension funds, insurance companies, etc. They buy a participating interest in the total pool of receivables and receive their payment in the form of interest and principal as per the terms agreed upon.

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4.4.3 OTHER PARTIES INVOLVED IN THE SECURITIZATION TRANSACTION: Obligers:They are the originators debtors. The amount outstanding from them is the asset that is transferred to the SPV. Here, the creditworthiness of the obligers holds importance. Administrator or Servicer: A person collects the payments due from the obligers and passes them on the SPV, remains in contact with the delinquent borrowers and handles legal remedies whenever required. As he/she receives the installments and pays them to the SPV, he/she is also called the receiving and paying agent. Agent and Trustee: It accepts the responsibility for overseeing that all parties to the securitization deal perform in accordance with the securitization trust agreement. Basically, it is appointed to look after the interests of the investors. Credit Enhancer:A bank or an insurance provider that provides credit support through a letter of credit, guarantee or other assurance. Liquidity Support Provider:It enables the SPV to make timely payments to the investors when there are timing differences in the receipt of interest and principal on pooled assets and servicing the securities. Swap Counter Party:It provides interest rate/ currency swap if required. Market Maker: Its supposed to offer two way quotes when the security is listed. Legal Council:A person who goes into the legal aspects of the deal and gives an opinion on whether the security has been legally perfected. Rating Agency:Since there is a risk to the investors on the asset pool rather than the originator, an external credit rating agency plays an important role. The rating process would assesses the strength of the cash flow and assesses the extent of credit and liquidity support required. Structure: In the ordinary course an investment banker is responsible for bringing together the originator, the credit enhancers, the investors and other parties to a securitization deal.

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STRUCTURE OF SECURITIZATION

Borrower obliger

Credit Enhancer

Originator

SPV

Investors

Rating Agency

Structure

4.4.4 STEPS IN SECURITIZATION: The main steps involved in the process of securitization are as follows: i) Selection of loans to be securitized: The loans which can be considered for securitization should have a reasonably predicable stream of future cash flows. It includes the loans granted against current assets, movable-fixed and also immovable-fixed assets. In case of current assets and movable fixed assets, the same would be under hypothecation. In the case of immovable-fixed assets, the same would be backed by mortgage. The main characteristics of assets that are most amenable to securitization include: STEPS: Identify the loans and the securities backing the loans

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 These loans and securities are then passed on to the SPV which can be a bank or any other institution and the transaction is normally in the shape of a sale for consideration. On completion of the sale transactions, the assets are removed from the balance sheet of the originators. The repayment from the borrower will continue to be received by the originators and the same will be passed on the SPV. The SPV will then notionally split the securitized assets into small shares, in the form of coupons known as PTC, for selling to investors. The investors, i.e. the PTC holders will claim interest and principal amount from SPV. Under securitization transactions, a PTC represents the sale of undivided interest to the extent of the face value of PTC in the aggregate pool of securitized assets. A PTC may be with recourse or without recourse. This affects the pricing of PTC. a) Asset size: The pool of debts to be chosen for securitization should consist of individual items of a relatively small size, spread over a number of borrowers in diverse geographical locations. Such a selection reduces the probability of credit loss and satisfies the rating agencies and the investors. b) Fixed repayment period: Since the investors primarily look forward to the streams of repayment of principal and interest rather than anything else for getting their repayment, loans having a regular repayment programme should alone be chosen for securitization. c) Homogenous maturity:The receivables selected for securities for securitization should be of a homogenous maturity period. Generally, receivables with maturities of one year or more should be chosen for securitization. d) Collateral characteristics:The collateral underlying the loans should be uniform, capable of being easily valued and readily marketable. Securities backed by such collaterals are given a higher rating by the credit rating agencies. ii) The sale of loans by the originators to the SPV: The assets are removed from the balance sheet of the bank once they are sold to the SPV. The terms, conditions and price paid in consideration of the sale are recorded in the form of a contract. A key objective in a securitization deal is to separate the credit risk of the originator from that of underlying assets, since it is the assets which provide the security for the investors. Types of funding range from asset-backed notes to asset-backed commercial papers through bank facilities secured on the assets.
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The fund raising may be either in the public or private market and may be rated by a least one of the established rating agencies. Different types of funding options can be offered to different groups of investors. iii) Structuring and issue of securities by SPV: Different structures will require different types of enhancement in order to ensure that the primary funding can be used in the most efficient manner. In order to reduce the vulnerability of these assets or to reinforce its ability to pay its investors, it is necessary to provide the following enhancements in varying degrees in different transactions: a) Credit enhancement: Different devices are used by the bank or the SPV for enhancing the acceptability of the securities by investors. The usual practice is to obtain a letter of credit or a letter of guarantee from reputed banks/FIs undertaking the payment of the investments in maturity just as alternate arrangements are made with insurance companies to compensate the loss which may be caused in the event of the borrowers difficulty to repay. Over and above these arrangements, the SPV can get the issue underwritten by reputed banks/FIs to increase the attractiveness of the investments besides ensuring its full subscription.

b) Credit rating:Like any other debt instrument, securities issued in the process of securitization need to be rated by a dependable credit rating agency. As better rating means easy marketability, the SPV must structure the transaction with skill, in order to ensure the same. c) Pricing:The proper pricing of securities is a critical element in the process of securitization. The rate of interest to be fixed should be competitive enough to attract investment but should not be so high as not to leave any spread for the other parties to the transaction. While it is difficult to give any ready-made formula for fixing the rate of interest on securities, some of the variations which determine the price are as follows: Type of credit rating. Type of credit risk with recourse or without recourse. Interest rates on other investment opportunities. d) Denomination of securities: The SPV notionally splits the pool of assets into small units or shares and issues certificates to the investors indicating the numbers of units/shares they hold in the common pool. These certificates are also called coupons or pay through certificates (PTC).

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iv)

Repayment of securities: The final step in securitization process is the repayment to the coupon holders. Under the agreement of securitization, the originator/lender continues to service the debt and agrees to pass on the recoveries to the SPV for distribution among the investors. In case the loan is not recovered, the loss is borne by the investors or the originators or the SPV, as the case may be, as per the terms of contract.

4.4.5ADVANTAGES OF SECRUTIZATION: Adherence to capital adequacy norms: Having the potential to take away the asset while retaining the earning capacity intact, it has appealed to many banks as a better strategy to be adopted instead of raising new capital. Better capital structure: The technology of securitization can be utilized for improving the following parameters of the lending institution which in turn, results in a healthy balance sheet: i) Debt-equity ratio: It can be improved by securitizing the assets and by utilizing the sale proceeds for payment of outside liability. ii) Return on assets: An important by-product of securitization is the improvement in the return on assets. iii) Return on equity: Securitization is a device to stop the dilution of return on equity which would have otherwise resulted because of increasing capital. In fact, many banks fear to go to market to woo the public as their return on equity, which is presently alarming low, will further deteriorate with infusion of fresh capital. Better funding option: Securitization provides an addition avenue for mobilizing funds from internal sources. As the sale proceeds of securitized assets is a receipt, it does not fall within the purview of Demand and Time Liabilities (DTL) and does not attract reserve requirement. This underscores the important of securitization as a source of funds. Increased liquidity and market share: The funds obtained from securitization increase the liquidity position of the bank. In turn, the increased liquidity strengthens the loan originating capacity of the bank-a process which allows the bank to grow stronger and stronger vis-a-vis its competitors by the ability to satisfy a customers needs better. Securitization also helps in retaining blue chip customers who are likely to sever connections due to funds constraint and banks inability to
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sanction new credits. Under such circumstances, a bank can originate a loan and sell the same immediately for securitization for whatever little margin it is worth and can retain the leadership for more profitable business in future. Asset and liability matching:The worst problem that hits banks in general is their inability to match resources with asset creation. This mismatching results either in heavy call money borrowing at an exorbitant price or unwanted idle funds. Securitization can be used as a tool for matching resources and the corresponding assets created. As assets are paid back, the recoveries are utilised to meet the obligation to the investors. Securitization enables a bank to separately compare the funding cost of the assets which are securitized vis-a vis the yield it provides, making it possible to create a structure to match the cost and the yield. Increased profitability: The real strength lies in its capability to increase the profitability of the bank. Though the asset is taken out of the books of the bank, earning on such assets remains constant, as, it continues to earn the spread by way of commission to service the debt.

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UNIT V 5. BANK MARKETING 5.1 NEED FOR BANK MARKETING 5.2 FACILITATING FACTORS 5.3 SPECIAL FEATURES OF BANK MARKETING 5.4 BANK MARKETING OBJECTIVES 5.4.1 GENERAL MARKETING OBJECTIVES 5.4.2 OPERATIONAL OBJECTIVES 5.5 CUSTOMER RELATIONSHIOP MANAGEMENT IN BANKS 5.5.1 FACTORS LEADING TO DEVELOPMENT OF CRM IN BANKS 5.5.2 STEPS TAKEN BY BANKS TO IMPROVE CRM 5.6 FINANCIAL INCLUSION 5.6.1 FINANCIAL EXCLUSION 5.6.2 MEANING AND DEFINITION OF FINANCIAL INCLUSION 5.6.3 KEY OBJECTIVE OF FINANCIAL INCLUSION 5.6.4 IMPORTANCE OF FINANCIAL INCLUSION 5.6.5 CHALLENGES IN THE WAY OF FINANCIAL INCLUSION 5.7 BANKING COMPLAINTS AND ITS SOLUTIONS THROUGH BANKING OMBUDSMAN 5.7.1 BANKING OMBUDSMEN AUTHORIZATION TO COMPLAINTS 5.7.2PROCEDURE FOR REDRESSAL OF GRIEVANCES UNDER BANKING OMBUDSMAN SCHEME 5.7.3 COMPENSATION TO COMPLAINANT

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5 BANK MARKETING Marketing is selling of bank schemes. Marketing is creating demand for products. Persuading the prospective customer to bank with us is marketing. Marketing is finding out customer needs. Deposit mobilization is marketing. Talking nicely and politely to the customer is marketing. Marketing aims at customer satisfaction. Marketing is highlighting positive features of our products and negative features of the products of our competitors. Going out of the branch to contact customer. The above samples of marketing are an assortment of relevant ideas on bank marketing. Each one has a definition of bank marketing based on their actual experience. But the basic questions still need to be addressed. Ideally speaking, the marketer should first determine the needs and expectations of the target group of customer. Then he should evolve a product tailor made to satisfy his needs. Thus first identify 100 prospective customers for our product. The next step would be to approach these people and explain the features of the product. Since some ground work has already been done in identifying likely customers of the product, chances are that a fair number (say 70) of them would agree to subscribe to it. Now what happens when one of these willing customers is invited to open his account at our branch? It is possible that we may be unable to open his account on his first visit itself due to any of the following reasons. The branch does not have the necessary application forms, register or other stationery. The concerned counter clerk is not aware of the accounting procedure of the product which may be a new one or the clerk or the officer is not enthusiastic about doing the needful immediately due to a variety of reasons like excessive work load or strained relationship with his superiors. The reason for the failure to deliver as promised is irrelevant prospective of the cause, the impact on the customers would be negative. This leads us to the second critical aspect of bank marketing the delivery aspect the marketer must ensure beforehand that he has all inputs available at his command for completing the transaction to the satisfaction of the
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customer.There is no point in marketing and then leaving the customer disappointed at the point of delivery. The third and the last, crucial aspect of bank marketing deals with customer satisfaction. It is a known fact, that achieving customer satisfaction is the ultimate aim of all marketing effort. But then, there have been legitimate queries. Are we doing marketing just for customer satisfaction or is it for achieving our targets of profits, deposits, advances, etc. No doubt our ultimate aim is profitability, but profits automatically flow out of customer satisfaction.

5.1 NEED FOR BANK MARKETING: Till liberlisation hardly any efforts were made bybanks to adopt the culture of marketing as exist in other business. But now he situation is different. Today Banks have accepted marketing as an integrated management function. Banking is one of those areas of business in India in which one can see toughest competition. Number of players is more. Banks have launched an array of products and services, especially on the retail front to match the competition. Marketing departments have been established at the corporate and controlling offices of the banks, specialized marketing staff is being recruited and field sales/marketing force has been created. Now, it is being realized by the banks that even to stay in the competition they will have to take the help of the marketing. This explains the need for bank marketing.

5.2 EVOLUATION OF BANK MARKETING FACILITATING FACTORS: Some of the important factors which have given an input for bank marketing movement in the country are discussed below: i) Financial disintermediation: The basic job of a banker is to accept deposits from investors/depositors and, after earmarking funds towards SLR and CRR requirements, to extend loans to borrowers for meeting their production and consumption needs. The difference between the loan interest rate and deposit interest rate is the bankers spread (Income). This is the process of financial intermediation in which banker in the centre place.

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FIGURE-5.1 Financial Intermediation

DEPOSITORS BANKER BORROWERS

------ ---

-------

Looking at the above process from another angle, the depositors has surplus funds which he wants to invest and earn a high income. On the other hand, the borrower need funds for production or consumption for which he is prepared to pay a price. Since it would ordinarily be difficult for a depositor to search for borrower directly, the banker act as an intermediary. If the desire of the depositors for a high, safe income and that of the borrower for a low cost hand-free loan can be satisfied without the intervention of the banker, both would certainly be quite happy. This is exactly what has been increasingly happening in INDIA for over two decades. The typical depositor and borrower, who were meeting in the banking hall ,are now increasingly meeting each other outside the banking hall. The much talked about equity culture in the country offers a ready example. A corporate borrower in need of funds floats an equity issue and investors invest in equity of the company directly. The intermediary is no were in the picture in this process. Similarly, there is the option of floating commercial paper for highly rated corporate borrowers whereby they can mobilise funds from the market directly at market determined rates which are almost invariably more favourable to them than the bank lending rate. As for the investors, besides the equity issue, there are other lucrative investment options offered by non banking financial agencies like the post office, UTI, Mutual funds and company fixed deposits. All these investment avenues and many other similar ones have flooded the Indian financial market during the last two decade or so. The common feature of all these processes is the same, underming the traditional banking function of an intermediary between the investor and the borrower. This is known as the process of financial disintermediation and is depicted in figure2.

FIGURE- 5.2 Financial disintermediation

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DEPOSITORS

BANKER

BORROWER

---- ---------- /|\

---------- /|\

|________________________________________________________________________________|

ii)

iii)

iv)

Impact of disintermediation: The central point to be noted is that the process of financial disintermediation cuts into the roots of the traditional banking as we have known it over the last several decades. And this is happening on both sides on the banks balance sheet. On the liability side, the deposit mobilization is threatened because alternative lucrative investment avenues have become available to investors on the asset side of banks balance sheets. The profitable opportunities for lending to corporate borrowers are threatened because they can now access cheaper and less cumbersome avenues of raising resources. In a nutshell the process of financial intermediation has posed a serious threat to the very survival and growth of basic healthy activities. Search for alternatives: In this scenario the banks have been frantically looking for alternatives to survive and thrive. It is here that the discipline of bank marketing has come to their rescue, if the bank customer does not want the traditional service of deposit acceptance, loaning, then what does he want? This question is being increasingly asked and answers are being evolved. Bank marketing has emerged as the principal survival strategy for banks confronted with an accelerating pace of disintermediation. Raising customer needs and expectations: Another fact of growth of Indian economy in recent years has been the phenomenal increase in the needs and expectations of the banking customers. The reasons for this development are many and some major trends that contribute in raising bank customers need and expectations are Wide spread of television including access to international channels Improvement in general standards of living Computer culture development in a big way Recent rise of the Indian middle class with considerable financial resources and what is more, a prosperity towards consumption The numbers of double income nuclear families is constantly on the rise Entry of foreign and private sector banks in India Job mobility Breakup of the joint family system in urban India Governmental intervention for protecting the interest of consumers
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 Rising financial clout . All these and many other similar developments have combined to produce a typical bank customer who is no longer prepared to accept things lying down. They have started harbouring higher expectations from banks to fulfill their new needs and has become (at least in urban areas) quite articulate about it. Banks cannot cope with recent development by continuing to do business with a take it or leave it mental attitude. If they do so they will either lose business since the customer has other option open to him. So what does the bank do? The answer lies in moving closer to the customer, getting to know his needs more thoroughly and marketing efforts to satisfy them. This is exactly what bank marketing is all about. It is quite clear, that as in the case of financial disintermediation here too bank marketing is more of a survival strategy for todays banker. v) Objective of Government policies: The objective of economic liberalization since 1991 was that the economic activity be determined increasingly by the market forces of demand and supply, to integrate the Indian economy with the global economy and gradually eliminate the elaborate system of governmental control and regulation of different sectors of economy. The impact of these fundamental changes was bound to be for the highly controlled and regulated banking industry in the country. As various banking activities like branch expansion, interest rate determination, statutory pre-exemption (like SLR and CRR) get increasingly deregulated, the banks will be driven by market forces of demand and supply. The emphasis on profitability and customer service would necessitate greater thrust towards meeting customer demands. There again the principle and strategies of bank marketing would be saving grace. vi) Competition: An offshoot of economic liberalization is the phenomenal growth in competition in the banking industry. The bank customer in India, today have a choice. When one has a choice, one usually goes to the best. And that would be the bank which understands the customer best. Here comes bank marketing in their efforts to increase business and profits. 5.3 SPECIAL FEATURES OF BANK MARKETING Marketing services cant be identical to the marketing goods. Unless we are well aware of their specialities, the marketing decisions cant be sensitive. For a bank marketer it is necessary to understand those special features and keep in minds the features to upgrade the quality of decisions. i) Tangibility vs. intangibility: Goods are found tangible having physical objects but the services are intangible and of non-physical nature. We can view and test
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a TV, a refrigerator, a car or so but we can only realize and feel the services offered by a bank or other service generating organizations. This makes the task of bank professionals a bit difficult service they are not in a position to present physically the service product. This is due to intangibility that we cant touch them, and smell them. Hence, while marketing services, we have to concentrate on benefits and satisfaction , a buyer can derive after buying the services. Thus the intangibility makes it essential that bank professionals improve the quality of their services and attempt to create a quality gap. The gap in quality is meant the existent qualitative difference in the goods and services produced and generated by the competitive organizations. There are a number of factors responsible for this gap. By improving the quality we can create a gap for those organizations/ banks who delay the process of innovation. The qualitative difference in goods or services succeeds in influencing the impulse of buyers since the desires come into action and the buying decisions are made. It is in this context that almost all the organizations have started realizing the instrumentality of quality up gradation in the process of market creation. ii) Seperability vs. inseperability: Bank create services and supply them. In the marketing of goods , we do not find this feature. Goods are produced, sold and consumed but the services are sold and then produced and consumed. To simplify the difference between the two we can say that services and their providers are the same. Let us discuss this principle with the help of an example. Let us visualise a situation where an account holder at the bank branch comes to get his passbook updated. It is a very normal , routine transaction. In bank marketing updating passbook is a product. This customer could have a variety of experiences while getting his passbook updated. Some of them are enumerated here. - The counter clerk greets him warmly, takes the passbook, immediately updates the entries in it and returns the passbook to the customers with a Thank you, Sir what more can I do for you? - The counter clerk accepts the passbook, pleads inability to update it immediately because of his heavy workload and requests the customer if he could either wait or come later to collect it. - The counter clerk is busy doing something, ignores the customer for 5/10 minutes and thereafter takes the passbook from him, keeps it in his drawer and asks the customer to come later to collect it.

The experience of the customer in these three examples would obviously be different. In the first scenario he would return home quite satisfied, in the
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second less satisfied and in the third scenario he would be quite dissatisfied. On the surface, the product purchased by the customer that is updating his passbook, is the same in all the three examples. Still customer satisfaction varies so dramatically in all three. This is because of the behavior of the counter clerk. This is mainly due to inseparability. We do not find the same with goods since the goods are produced at different points and are sold at different point. Thus the bankers or the bank professionals need more professionalism to satisfy the customers. iii) Trasferability vs. non-transferability: If we market goods, the ownership, the title can be transferred to an individual or an organization buying the same. But the services cannot be transferred. If we have an account in a bank and want to transfer the same to other person, it is not possible. We always find a direct deal between the providers and receivers. Thus the benefit of transfer which is found in the marketing of goods is not found in the marketing of banking services. Hence, bank marketer should develop more excellence in taking the support of face-to-face communication, while marketing his service Simultaneity: Services do not move through the channels of distribution. Hence, either users are brought to services or providers go to the users. It is right to say that services have limited geographical area. The bank account, the core or peripheral services offered by a bank cannot be brought to the customers. If we are interested in using the services, we have to approach or have to move through the defined provisions determined and defined by the providers. Rating the quality: Rating of quality is found easier for goods since the standardization is possible but the rating of quality of services can be measured in terms of service level. In the marketing of goods, the goods to be delivered to the customers act as a motivational tool but we do not find the same effect in marketing the banking services. Since the users cannot be motivated in the same way the delivery is just a feeling and the different users can be discriminated on that account. Documentation: In marketing goods we get an opportunity to collect and document the evidence in our support. We find grading, standardization, quality specification or so. But the promises regarding the services full filled or not full filled cannot be documented. In the front line personnel misbehave, the concerned user fail or find it difficult to testify. On the other hand if the banker behaves decently, but the users are biased and complaints are lodged then the concerned bankers find it difficult to prove. This of course complicates the task of both the banker and the user of the service.

iv)

v)

vi)

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vii)

Sensitivity: The high intensity of sensitivity is meant less scope for re-dressal of the users grievances. In the true sense, the marketing of banking service is influenced by the use of a particular moment. In the marketing of goods we get time to convince. Thus the delivery of the services is personalized.

In service generating organizations professionalism plays an incremental role. In addition to the services promised, the behavioural dimention also influences the impulse of the customers. It is in this context that almost all the service generating organizations need to assign due weightage to the behavioural profile, preferably of the front line staff.

5.4 BANK MARKETING OBJECTIVES Before a banker formulate a marketing strategy it is essential that he knows about the marketing objectives. We cannot ignore the fact that the process of setting the objectives enables an organization / bank to answer the key question where do they want to go? It is very natural that people are much more motivated when they work to achieve a particular goal such as passing an examination, getting a promotion, increasing savings for buying a car or so. Organizations benefit from the setting of goals in the same way as we find in the case of individuals. On a practical level, the existence of clear objectives improves co ordination between departments and prevent potentially disastrous situation. Most well run organizations set objectives which are challenging yet realistic and try to involve staff at all levels in formulating these objectives, all though broad strategic objectives would invariably be decided by senior management at corporate level. The overall bank marketing objectives include general marketing objective and operational objectives of the bank. It is essential that a bank marketer is well aware of the general and branch level objectives. This helps him in ordering the priorities and formulating the strategies. These are discussed below: 5.4.1 GENERAL MARKETING OBJECTIVES: The general marketing objectives concentrate on the broader objective. This include increasing the market share, maximizing the profitability and expanding the business. i) Increasing the marketing share: It is significant to mention that while targeting the market share, the emphasis should be on the total market for the bank. The market share is share of concerned bank in the total market in which all the competitive banks are operational in business. The planners at apex level consider the internal and external business conditions and set objectives accordingly but the bank executives working in different branches are supposed to know that the total market share vis--vis the market share which is targeted for a particular area. This
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is a general business objective determining the other objectives such as maximizing the profits and expanding the business. ii) Maximising the profitability : Profit is income minus cost and the income generating units are bank branches. While computing the profitability for a bank the Head Office consolidate the financial statements of all branches. For maximizing profitability it is essential that the productivity is accelerated. The planners at the apex level attempt to optimize the branch expenses for increasing the productivity but while doing such they should not over look the potential requirement of the concerned branch since this complicates the task of branch managers. iii) Expanding the business: This objective includes both type of developments, such as expanding the number of branches in different segments and increasing the total market share. An expansion in a business is possible in the banks at apex level have been practicing innovative marketing and at the same time have also been setting guidelines for different branches of course in the face of the development in the concerned command area. This is mainly influenced by the intensity of the competition. If there is fierce competition, the task of expanding the business becomes difficult since it is also to affect the cost and productivity. OPERATIONAL OBJECTIVES: We cant deny the fact that the operational objectives determine the rate of success since whatever the positive developments we find at the apex level are the aggregation of the contributions of the different branches working in different areas. The operational objectives are set by the branch managers and therefore the branch managers also need professionalism specially to order the priorities in the face of developments found or expected in the branch.

i) Increasing the branch business: This is related to an increase in the business of a

particular branch. It is natural that an increase in the accretion of savings and deposits results into an increase in the business of the branch. It is also significant to mention that an increase in the business of branch may or may not increase its market share. This is determined by the relative efforts and rate of success of the branches of competitive banks. If there is an increase in the business of a branch and the competitive branches fails in increasing their business up to that proportion an increase in the market share is possible.

ii) Increasing the market share - In this context the emphasis is on increasing the
market share of a particular branch. This is share of a branch in the total business of different competitive branches in a particular area. The bank executive working in branches while setting the objectives related to an increase in the market share are supposed to consider the potentials of the branch and the market potentials. This helps the manager in formulating a strategy to sensitise the potential investors. On the basis of a detailed study of the area, a branch manager identifies the most
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profitable segment or group and adopts innovative marketing practices to influence their impulse.

iii) Increasing the profitabiltity: This is related to an increase in the profitability of a

particular branch. The branch managers in this context are supposed to look at the following: Profit to average deposits Expenses on employees (average) Volume of working funds per employee Spread to deposits Burden to deposits Non performing assets / business assets x 100 Return on total working fund An increase in profitability makes it essential that branches which are close to the break even point endevour to cross it. In addition, the branches earning pofits are also supposed to improve the profits progressively and the branches showing loss are required to reduce it progressively. 5.5 CUSTOMER RELATIONSHIP MANAGEMENT IN BANKS (CRM) In a rapidly growing environment, because of the opening up of banking sector in India, the focus is now on the customer. Higher the revenue earnings, high profits and higher market shares will flow only from the new customer. The customer has become more discerning as how he has the power to choose his banker from a large number of public sectors, private sector, foreign and co-operative banks. The customer can thus decide the fate of the Individual banks. Many banks the world over, have realized that the customers needs have to be addressed more seriously than ever before. The perception of a bank is based on the customers varied experience with the bank employees. It is a proven fact that it costs more to bring in a new customer than to retain an existing customer. Furthermore, the choices open to customers today are so much more. Here, Information about the customer is the key to success. There is a need for better understanding of the customer is the key to success. There is a need for better understanding of the customers and what they expect from the organization. This Information is like oxygen for the business to survive. Only those banks which can continuously monitor, understand and meet customer needs, streamline their processes so as t o make them less rigid and are more customer oriented would be better equipped to survive the competition.CRM is primarily a marketing tool used by the companies to acquire new customers, satisfy them and finally retain them. CRM is defined as A strategy used to learn more about customer needs and behavior in order to develop strong relationship with them. CRM is not only a technology solution but also an important strategy business and process Issue which an organization employs
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to Identify, select, acquire and retain customers. The role of CRM is to deliver customized features and attributes to meet various customer needs and wants, then building loyalty. Loyalty is a term used in business concepts to describe a customers willingness to continue patronizing a firm over the long term by purchasing and using its goods and services on a repeated basis and recommending to others through word of mouth. FIGURE 5.3: COMPONENTS OF CRM

5.5.1 FACTORS LEADING TO THE DEVELOPMENT OF CRM IN BANKS CRM as defined by Philip Kotler is the process of utilizing detailed Information about Individual customers and carefully managing all the customer touch points with the aim of maximizing customer loyalty. The main objective of the CRM Process is to create a new powerful tool for customer retention. The success of CRM depends purely on the process, and can be measured in terms of future revenue, customer value, customer retention, customer acquisition and profitability. CRM has many advantages if understood and put into practice properly. The following are the principle benefits of CRM: Ability to retain loyal and profitable customers for rapid growth of business. Acquiring the right customers based on known characteristics, which drives growth and Increases profit margins Increasing Individual customer margins while offering the right products at the right time. The CRM Process in banking is essentially directed to meet the following purposes: i. Identifying the customers: It is necessary for banks to identify potential customers for approaching them with suitable offers. The transactional data that is generated through customer interaction and also the profile of the customers
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such as the life cycle stages, family commitments, etc., need to be collated into one database to ensure proper analysis. The data generated through services such as ATM cards, home loan, etc. need to be integrated to enable effective targeting. After the integration is done, a profitability analysis of the customers needs to be undertaken to get an understanding of their profile worthiness before targeting him with new offers. ii. Customer segmentation: Banks can use customer data to effectively segment the customer before targeting them By applying data mining tools, clusters of similar records can be made, From this one can arrive at a list of customers who are more likely to respond to a new loan system , a new deposit scheme , etc. This will help in finding a highly targeted market. iii. Prediction: Data mining tools can build a classification system based on past data, taking a number of parameters into consideration. With this, a new customer behavior can be predicted with reasonable accuracy. The same principle can be adopted during a product launch. advertising and pricing strategy. iv. Customer Loyalty Analysis: To develop effective customer retention programs, it is important to analyze the reasons for customer attrition. Data mining tools can help understanding customers in detail. One can drill down to even individual competitor. v. Cross selling: Based on the previous service taken from the bank, data mining tools can provide a wealth of Information about the association between two services. This can be used in building a strategy for promotion or selling more services to customers at the time of contact. vi. Customer Lifetime Value (CLTV): Customers who are not profitable today may have the potential of becoming profitable in the near future. Hence it is absolutely essential to Identify persons with high income value. CRM tools are designed to calculate CLTV in different business environment. This can also help in

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vii.

Product Pricing: Using data warehousing and data mining tools sophisticated pricing models can be developed, which can establish price-sale relationship for different services and the relationship between changes in prices and sales.

viii.

Assisting the sales force for effective campaign: A consolidated data base for all products, pricing, competitor Information, sales presentation, proposal templates and marketing collateral should be accessible to all the people concerned. This would prove very helpful in sales force automation wherein, the salesperson gets instantaneous access to all the relevant material, especially when the sales person is meeting a client.

ix.

Proper Interface with Customer: Communication from various departments should be consistent and not contradictory. Therefore all departments should be carrying a unified view of the customer to enable a consistent approach. Removal of inconsistency is necessary to ensure that customers are not harassed and frustrated. This is very important to ensure customer satisfaction. The contact centers which are used to interface with the customer should ensure that they are consistent with each other irrespective of the medium used for interaction.

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FIGURE 5.4: FACTORS INFLUENCING DEVELOPMENT OF CRM

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FIGURE 5.5: CUSTOMER IDENTIFICATION

5.5.2 STEPS TAKEN BY BANKS TO IMPROVE CRM: The use of CRM in banking has gained importance with the adoption of aggressive strategy for customer acquisition and retention by the banks in todays competitive era. Some of the CRM initiatives of banks are: To maintain constant interaction with facilitating the banks to evaluate, Banks offer various customer friendly deposit schemes and personal loans to suit different needs of the people.
It provides various services such as locker facility and Utility bill payment facility among others.

It also offers loans to small and medium enterprises to help them grow in their business. The banks provide credit facilities to retail traders in the form of swift loans and property loans. It also offers corporate loans to existing companies to meet their financial needs. The banks also offer variety of Retail Loan Products such as, car loan, home loan, etc. It also provides a wide range of products from traditional term loan to short term products. Some of these services are:

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i.

Easy pay scheme:

Banks have introduced the easy pay scheme to make

recurring utility bill payments such as electricity bill, Insurance premium, etc. For this the customer has to register themselves with the bank branch and all the future bills will be paid automatically through the customers bank account. ii. ATMservices: Banks Issue ATM cards to all its customers who open an account with it. Customers can draw cash from ATMs of banks as well as member banks in BANCS network. For drawing cash from ATMs of consortium banks, no charges are levied. iii. Debit card: RBI has allowed banks to offer debit cards to its customers not only in India but also across the world. The customers can also use it for making payment at any point of sales as well as for Internet transactions of all types. iv. Mobile banking: Banks have introduced mobile banking to enable customers to obtain Information about their accounts. Mobile banking provides messages of both types: push and pull. In push message banks send SMS alert of cash transactions above Rs.5000 and also for demit transactions. In pull messages customers can check their bank accounts and find out the details of last five transactions by sending SMS to a given number. v. Mutual funds: Rising disposable Income has created huge potential for Investments in Insurance and Mutual funds. Considering the Indian demographical Profile (more than 70% of the population below the age of 35) Changes in Investment patterns and thinning of Interest margins, the Indian banking Industry had to redesign it s products and get into marketing of third party products like Insurance and mutual funds to Increase fee based Income. vi.

Insurance:

Banks have tied up with Insurance for marketing various life

Insurance schemes such as endowment policy, regular assurance plan, etc. Also for non-life Insurance the banks have tied up with an Insurance company. Under this arrangement the banks offer the following products: Health guard that covers hospitalization expenses for illness and injuries. Travel companion which covers reimbursement of medical expenses abroad and also loss of passport/ baggage during overseas travel.
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 Personal Accident Insurance that covers the risk of death due to accident. Vehicle Insurance that covers the risk of damage or loss of vehicles. vii. Anywhere banking: Banks offer its customers the facility of anywhere banking with the clearing and quick collection of outstation cheques. Customers can withdraw cash from their accounts in any of the bank branches with the support of core banking solutions. The business associates of the customers can remit money to their accounts instantaneously through any of the branches. The facility is extended to savings, current and overdraft accounts. Customers can also transfer funds from one account to another and can check balance and details of transactions and also to get their passbooks printed from any of banks branches. viii. Demat Account: The banks offer the facility of opening demits account to its customers. This helps the customers in trading and settlements of shares and securities easily and expeditiously. ix. Internet banking: loan account, etc x. Foreign Exchange: Banks have a license from RBI to deal in Foreign Exchange. The banks offer credit finance by way of pre-shipment and post-shipment credit. It also provides credit for purchase of raw materials which is generally given for 90 to 180 days. CONCLUSION: In todays environment of growing competition, dynamic market situation, entry of foreign banks and increasing use of online channels for communication and transactions, it has become extremely difficult for the urban co-operative banks to stay ahead of competitors. Many banks have understood the Importance of retaining customers and corresponding lifetime value of customers are turning towards Implementing CRM in their organization. CRM has found relatively higher and more successful Implementation in the financial service Industry. Customer Intimacy or relationship with customers is observed as one of the competitive differentiators in this Industry. With Increased Income levels, customers are now looking for better banking facilities. Banks that understand the need for customers and transform themselves accordingly are definitely benefiting from the long
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Banks offer Internet banking facilities to its customers by

whom customers can access Information about linked account, cheque status,

term loyalty of the customers. The Importance of adapting oneself to the changing needs of the customer is compelling the banks to adapt to a more customer friendly operational systems. 5.6 FINANCIAL INCLUSION INTRODUCTION The majority of the poor in India, especially those working in informal sector like small and petty vendor , home-based workers, artisans, laborers, maid servants, desperately need financial services from formal financial institutions. The reason is that they are involved in economic activities in which they need working capital. They also need credit or term loans to buy equipment like sewing machines or cutting machines or livestock or handlooms. There is also a need for credit for improving their huts or houses, for adding water and drainage services in their living place, or for getting electronic connections. These are all their needs for running economic activities. Mainly because they are self employed or working on their own. Because of their nature of work , poor living and working conditions, and low income level , they are very vulnerable and susceptible to many types of risks,i.e; accident,death,cyclone,and fire. They need to be protected under these risks. They also want to build little savings for their future needs .Vulnerability during their entire working life does not allow them to build up or plan for their old age. The poor need credit, insurance, savings, and pension services. But because of lack of access to these financial services from formal sector, they have to depend on informal financial sources, i.e., private money lenders. Not only are these informal sources exploitative, they provide only credit services and do not provide other financial services like savings, insurance, pensions and remittances. As a result, the poor are caught in a debt trap; they borrow at very high interest rates for all types of life-cycle needs, whether it is a business need or a personal need like sickness or accident or a social need like marriage. If the objective is to bring these economically poor out of the vicious cycle of poverty and help them build their own capital asset and business, there is a need to ensure that they get access to integrated financial services, and that too from formal financial at a reasonable price. 5.6.1 FINANCIAL EXCLUSION The term exclusion is used in different ways. It can be a broad concept related to lack of access to a range of financial services or a narrow concept reflecting particular circumstances such as geographical exclusion, exclusion on the grounds that changes and prices are high or exclusion from marketing efforts. self exclusion is also important where an individual believes there is little point in applying for financial product because they
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expect to be refused, sometime because of a previous experience or refusal, because they know someone else who has been refused , or because of own belief. These aspects of exclusion are not mutually exclusive. They will overlap and reinforce each other, resulting in individuals, household and communities having little or no connection to main stream banking and financial services. In India, financial exclusion of an individual would be of this five reason-no assets, no saving, no bank account, affordable credit and no access to financial advice (counseling) financial exclusion arises from the inter-related problems of poverty ignorance and environment. Poverty : As being on a low income. They are always excluded from the financial services. Ignorance : Ignorance or low levels of awareness and understanding about financial products and this is due to financial illiteracy and lack of appropriate marketing process. Environment :Poor access to financial services also caused due to several factors which includes i) Geographical access to bank branch or remote banking facilities. ii) Regulatory barriers such as laundering guidelines requiring proof of identification, which many people find difficult to provide. iii) Cultural & psychology barrier such as language perceived/ actual racism or fear of financial institutions.

The reason may vary and hence the strategy could also vary but all out efforts are being made as financial inclusion can truly lift the financial condition & standards of life of the poor and disadvantaged. 5.6.2 DEFINITION AND MEANING OF FINANCIAL INCLUSION The committee on financial inclusion under the chairmanship of Dr. C. Rangarajan has defined financial inclusion as the process of ensuring access to financial services, and timely and adequate credit as needed by vulnerable groups such as weaker sections and low income groups at an affordable cost.

Financial inclusion delivery of the banking services at an affordable cost to vast section of disadvantaged and low income group. The key focus of financial inclusion includes four products.

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-A pure savings product with inbuilt overdraft facility -A recurrnig deposits product -A remittance product and -Entrepreneurship credit in the form of known credit card (KCC) 5.6.3 KEY OBJECTIVE OF FINANCIAL INCLUSION: -Extending formal banking system among less privileged in urban & rural India. -Weaning them away from unorganized money markets and money lenders. -Equipping them with the confidence to make informed financial decisions. 5.6.4 IMPORTANTS OF FINANCIAL INCLUSION Equitable growth is achievable only through the financial inclusion. There are hardly any instances of an economy transiting from an agrarian system to a post-industries modern society without broad based financial inclusion. Accessibility of public goods and services is a necessary condition of an open and efficient society. Banking services are like public goods, it is essential that the availability of banking services to the entire population is ensured.

Financial access is essential by meant for the economically backward as it provides them opportunities to build savings, make investments and avail credit. Importantly, access to financial services also helps the poor insure themselves against income shock and equips them to meet emergencies, such as illness, death in the family or loss of employment. Needless to add, financial inclusion protects the poor from the clutches of the usurious moneylenders. It is well understood with the experience of FMCG companies, LIC, microfinance companies that commerce with the poor is more viable and profitable, provided there is ability to do business with them. The availability of uncomplicated, small, affordable products can help bring low-income families into the formal financial sector. Taking into account their seasonal inflow of income from agricultural operations, migration from one place to another, and seasonal and irregular work availability and income, the existing financial system needs to be designed to suit their requirements. Mainstream financial institution such as banks has an important role to play in this effort.

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 Financial inclusion benefits banking sector in two ways. First, financial inclusion provides an avenue for bringing the savings of poor into the formal financial intermediation system and channels them into investments. Second, the large amount of low cost deposits offer banks an opportunity to reduce their dependence on bulk deposits and help them to better manage both liquidity risks and asset liability mismatches. The ongoing financial inclusion effort over the last six years driven by RBI with policy support from Government of India pursues the objective of providing effective and affordable access to savings, credit, remittance and insurance services to the people that have remained outside the formal banking channels. The RBI has operated on product, process, institution and policy levels in its pursuit of a bank-led financial inclusion solution for people, especially in rural areas.

ASPECTS OF INTERVENTION Product Process Institution Policy

SPECIFICS No frills accounts , general credit cards , overdrafts bundled with No-frills accounts(NFAs) Simplified account opening, disbursement of Government payments such as NREGS wages. Business correspondent and business facilitator arrangements. Relaxed KYC norms for NFAs support from financial inclusion technology fund (FITF) and financial inclusion fund (FIF) for banks.

The efforts at different levels had yielded results in terms of increased number of people linked to the banking system.

5.6.5 CHALLENGES IN THE WAY OF FINANCIAL INCLUSION The major barrier for financial inclusion, apart from socioeconomic factors such as lack of regular income, poverty, illiteracy, etc... Lack of reach, higher cost of transaction and time taken in providing those services. In vast country like India viable models for remote areas are difficult to design. Appropriate business model to suit urban poor and rural people. Efficient delivery mechanism needs to be identified.
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Financial literacy and financial education need to be taken up on large scale. Lack of ownership by banks in implementation of financial inclusion. Lack of co-ordination among different entities. Information and communication technology (ICT) based BC model yet to stabilize. Infrastructure problem- premises, roads, power, etc. Fewer transactions non operational accounts high volume small value transactions- high cost viability issues. Technology issues availability of handheld devices, cards, technology partners, operational glitches, digital connectivity, and turnaround time. Engaging BCs associated risks- lack of professionalism of BCs. BC attrition.

5.7 Banking complaints and its solutions through Banking Ombudsman

customer complaints against banks spiked by 44% in the financial year ended 31 March 2009.According to Reserve Bank of India(RBI) data complaints from rural areas alone jumped by 65%.The increase in customer dissatisfaction has prompted banking regulator RBI to issue general directions to all banks to protect customers against ban ks & apes; act of commissions and omissions.

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The surge in complaints comes even as banks increase their technology use to improve services and expand their presence in rural areas to promote financial Inclusion. Ironically, both these measures contributed to the growth in customer dissatisfaction. Complaints relating to credit and automated teller machine cards were most common, accounting for 25.5% of the complaints. They jumped 74% over the previous year. The report, released by RBI governor D. Subarea, said increased penetration of banking, growing awareness and higher expectations of customers in rural areas were the main reasons for the larger number of complaints. According to the report prepared by RBI customer services against banks grew to 69,117 in fiscal 2009, up against 47,887 in fiscal 2008. Bank Ombudsman Scheme The Ombudsman Scheme is a system of expeditious and inexpensive resolution to customer complaints. It enables an expeditious and inexpensive forum to bank customers for resolution of complaints relating to certain services rendered by banks. The Banking Ombudsman Scheme is introduced under Section 35 A of the Banking Regulation Act, 1949 by RBI with effect from 1995. The Banking Ombudsman is a senior official appointed by the Reserve Bank of India redress customer complaints against deficiency in certain banking services. As on date , fifteen Banking Ombudsman have been appointed with their offices located mostly in state capitals like Ahmadabad, Bangalore, Bhopal, Bhubaneswar, Chandigarh, Chennai, Guwahati, Hyderabad, Raipur, Kanpur, Kolkata, Mumbai, New Delhi, Patna and Thiruvananthapuram. All Scheduled Commercial Banks, Regional Rural Banks and Scheduled Primary Co-operative Banks are covered under the Scheme. Functions of Banking Ombudsman 5.7.1 Banking Ombudsmen have been authorized to look into the complaints concerning i. Deficiency in banking service non-payment or inordinate delay in the payment or collection of cheques, drafts, bills etc.; non-acceptance, without sufficient cause, of small denomination notes tendered for any purpose, and for charging of commission in respect thereof;

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 non-acceptance, without sufficient cause, of coins tendered and for charging of commission in respect thereof; non-payment or delay in payment of inward remittances; failure to issue or delay in issue of drafts, pay orders or bankers cheques; non-adherence to prescribed working hours ; failure to provide or delay in providing a banking facility(other than loans and advances ) promised in writing by a bank or its direct selling agents; delays, non-credit of proceeds to parties accounts, non-payment of deposit or non-observance of the Reserve Bank directives, if any,applicable to rate of interest on deposits in any savings,current or other account maintained with a bank; complaints from Non-Resident Indians having accounts in India in relation to their remmitances from abroad, deposits and other bankrelated matters; refusal to open deposit accounts without any valid reason for refusal; levying of charges without adequate prior notice to the customer; non-adherence by the bank or its subsidiaries to the instructions of Reserve Bank on ATM/Debit card operations or credit card operations; non-disbursement or delay in disbursement of pension (to the extent the grievance can be attributed to the action on the part of the bank concerned, but not with regard to its employees); refusal to accept or delay in accepting payment towards taxes, as required by Reserve Bank/Government; refusal to issue or delay in issuing, or failure to service or delay in servicing or redemption of Government securities; forced closure of deposit accounts without due notice or without sufficient reason; refusal to close or delay in closing the accounts; non-adherence to the fair practices code as adopted by the bank or non-adherence to the provisions of the code of Banks commitments to Customers issued by Banking Codes and Standards Board of India and as adopted by the bank; non-observance of Reserve Bank guidelines on engagement of recovery agents by banks; and any other matter relating to the violation of the directives issued by the reserve bank in relation to banking or other services.

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. ii. Deficiency in service with respect to loans and advances

non-observance of Reserve Bank Directives on interest rates; delays in sanction, disbursement or non-observance of prescribed time schedule for disposal of loan applications; non-acceptance of application for loans without furnishing valid reasons to the applicant; and non-adherence to the provisions of the fair practices code for lenders as adopted by the bank or Code of Banks Commitment to Customers, as the case may be; non-observance of any other direction or instruction of the Reserve Bank as may be specified by the Reserve Bank for this purpose from time to time. The Banking Ombudsman may also deal with such other matter as may be specified by the Reserve Bank from time to time.

5.7.2 The procedure for the redressal of grievances under the Banking Ombudsman Scheme: i. Any person whose grievance against a Bank is not resolved to his satisfaction by the Bank within a period of 60 days, he can approach the Banking Ombudsman if his complaint pertains to any of the matters specified in the scheme as explained above. Written complaint is to be lodged by a person or an authorized representative. One can file a complaint with the Banking Ombudsman simply by writing on a plain paper. One can also file it online or by sending an email to the Banking Ombudsman. The Banking Ombudsman does not charge any fee for filing and resolving customers complaints. Complaint shall include signature of the complainant or an authorized representative along with the name, address and also name and address of the bank office/branch along with supportive documents, the nature and extent of the loss incurred and the relief sought from the Banking Ombudsman and a statement about the complaince of the conditions referred to in Subclause (3) of this clause.
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ii.

iii. iv.

v.

One may lodge his/her complaint at the office of the Banking Ombudsman under whose jurisdiction; the bank branch complained against is situated. vi. For complaints relating to credit cards and other types of services with centralised operations, complaints may be filed before the Banking Ombudsman within whose territorial jurisdiction the billing address of the customer is located. vii. No complaint to the Banking Ombudsman shall lie unless:

One has not approached his bank for redressal of his grievances first. The complaint is made one year after the rejection of the
representation by the bank or dispatch of final reply by the bank on the represention. The complainant is not in receipt of the same subject matter if settled by the Banking Ombudsman in previous proceeding/s whether received from the same complainant or any one or more of the parties concerned with the subject matter. The complaint is not the same subject matter, for which any proceedings before any court, tribunal or arbitrator or any other forum is pending or a decee or Award or order of dismissal has already been passed by any such court, tribunal, arbitrator or forum. The complaint if not frivolous or vexatious in nature. The institution complained against is not concerned under the scheme. The subject matter of the complaint is not within the ambit of banking Ombudsman.

Ombudsman would make recommendations after listening to both parties. In case the recommendation made by the Banking Ombudsman is not accepted by either of the parties, Banking Ombudsman proceeds to make an award. The Banking Ombudsman provides reasonable opportunity to the complainant and the bank, to present their case. It is up to the complainant to accept the award in full and final settlement of the complaint or to reject it. If one is not satisfied with the decision passed by the Banking Ombudsman, one can approach the appellate authority against the Banking Ombudsmens decision. Appellate Authority is vested with a Deputy Governor of the RBI. One can also explore any other
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recourse and/or remedies available to him/her as per the law. The bank also has the option to file an appeal before the appellate authority under the scheme. If one is aggrieved by the decision, one may, within 30 days of the date of receipt of the award, appeal against award before the appellate authority. In case of decay the appellate authority may, if he/she is satisfied that the applicant had sufficient cause for not making an application for appeal within time, also allow a further period not exceeding 30 days. The following are the powers of appellate authority: dismiss the appeal; or allow the appeal and set aside the award; or send the matter to the banking ombudsman for fresh disposal in accordance with as such directions as the appellate authority may consider necessary or proper; or modify the award and pass such directions as may be necessary to give effect to the modified award; or Pass any other order as it may deem fit.

5.7.3 Compensation to Complainant The amount, if any, to be paid by the bank to the complainant by way of compensation for any loss suffered by the complainant is limited to the amount arising directly out of the act or omission of the bank or Rs 10 lakhs, whichever is lower. The Banking Ombudsman may award compensation not exceeding Rs 1 lakh to the complainant only in the case of complaints relating to credit card operations for mental agony and harassment. The Banking Ombudsman will take into account the loss of the complaints time, expenses incurred by the complainant, harassment and mental anguish suffered by the complainant while passing such award.

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